Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-1
Developed By:
Dr. Don Smith, P.E.
Department of Industrial
Engineering
Texas A&M University
College Station, Texas

Executive Summary Version
Chapter 4
Nominal and Effective
Interest
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-2
LEARNING OBJECTIVES
1. Nominal and effective
interest rates
2. Effective annual interest
rates
3. Effective interest rates
4. Compare PP and CP
5. Single amounts
with PP CP

6. Series with PP CP
7. Single and series
with PP < CP
8. Continuous
compounding
9. Varying interest
rates

Notation:
CP = Compounding Period PP = Payment Period
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-3
Sct 4.1 Nominal and Effective
Interest Rate Statements
Review simple interest and compound interest
definitions (from Chapter 1)
Compound Interest
Interest computed on interest
For a given interest period
The time standard for interest computations One Year
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
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4-4
Nominal Rate of Interest
Nominal interest rate definition:
An interest rate that does not include any
consideration of compounding

For example, 8% per year is a nominal rate
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-5
Effective Interest Rate
Definition:
The effective interest rate is the actual rate
that applies for a stated period of time.
The compounding of interest during the time
period of the corresponding nominal rate is
accounted for by the effective interest rate.
The effective rate is commonly expressed on
an annual basis denoted as i
a

All interest formulas, factors, tabulated values, and spreadsheet relations must
have the effective interest rate to properly account for the time value of money.
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
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2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-6
Three Time Based Units
Time Period The period over which the interest is
expressed (always stated).
Ex: 1% per month
Compounding Period (CP) The shortest time unit
over which interest is charged or earned.
Ex: 8% per year, compounded monthly
Compounding Frequency The number of times m
that compounding occurs within time period t.
Ex: 1% per month, compounded monthly has m = 1
Ex: 10% per year, compounded monthly has m = 12

One Year is segmented into: 365 days, 52 weeks, 12 months
One quarter is: 3 months with 4 quarters/year

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-7
The Effective Rate Per CP
% per time period t r

m compounding periods per t m
r
=
The Effective rate per compounding period (CP) is:
Ex: r = 9% per year, compounded monthly:
m = 12 .(12 months in a year)
i per month = 0.09/12 = 0.0075 or 0.75%/month
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-8
Two Common Forms of Quotation
Two types of interest quotation:
1. Quotation using a Nominal Interest Rate
2. Quoting using an Effective Interest Rate
Nominal and Effective interest rates are common in
business, finance, and engineering economy
Each type must be understood in order to solve
problems where interest is stated in various ways
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-9
Definition of a Nominal Interest
Rate
+ Nominal interest rate definition:
An interest rate that does not include any consideration of
compounding

+ Means in name only, not the true, effective rate

+ 8% per year, compounded monthly
8% is NOT the true effective rate (per year)
8% represents the nominal rate
Effective rate will consider the monthly compounding
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-10
Examples of Nominal Interest
Rates
1.5% per month for 24 months
Same as: (1.5%)(24) = 36% per 24 months
1.5% per month for 12 months
Same as: (1.5%)(12 months) = 18%/year
1.5% per 6-month period for 1 year
Same as: (1.5%)(2 six-month periods) = 3% per year
1% per week for 1 year
Same as: (1%)(52 weeks) = 52% per year
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-11
Sct 4.2 Effective Annual Interest
Rate
r = nominal interest rate per
year
m = number of
compounding periods per
year
i = effective interest rate
per compounding period
(CP) = r/m
i
a
= effective interest rate
per year
1/
(1 ) 1
m
eff a
i i = +
r/year = eff i / CP ) X (CP / year)
=(i)X(m)
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-12
Sct 4.3 Effective Interest Rates
for Any Time Period
How to calculate true, effective, annual interest rates.
We assume the year is the standard of measure for time.
The year can be comprised of various numbers of compounding
periods (within the year).

Equation [4.8] in the text is the effective interest rate
relation

r
i = (1+ ) 1
m
m
Effective
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
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Example: Calculating the Effective
Rate
+ Interest is 8% per year, compounded quarterly
+ What is the effective annual interest rate?
+ Use Equation [4.8] with r = 0.08, m = 4
Effective i = (1 + 0.08/4)
4
1
= (1.02)
4
1
= 0.0824 or 8.24%/year
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-14
Sct 4.4 Equivalence Relations:
Lengths of Payment Period (PP)
and Compounding Period (CP)
To be considered:
Frequency of cash flows may or may not equal
the frequency of interest compounding
If the frequency of the cash flow equals the
frequency of the interest compounding No
Problem!
If not, must make adjustments
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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4-15
Situations
Situation Text Reference
+PP = CP Sections 4.5 and 4.6
+PP > CP Sections 4.5 and 4.6

+PP < CP Section 4.7
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-16
Sct 4.5 Equivalence Relation:
Single Amounts with PP CP
There are only single amount cash flows, that is, P and F values

To determine P or F using P = F(P/F,i,n) or F = P(F/P,i,n), there are
two equivalent methods to determine i and n in the factors.

Method 1. For the effective interest rate, i, in the factor:
Determine i over the CP using i= r/m

For the total number of periods, n, in the factor:
Determine the number of CP between
occurrence of P and F values using
n = (m)(number of payment periods)


Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-17
Sct 4.5 Equivalence Relation:
Single Amounts with PP CP
There are only single amount cash flows, that is, P and F values

To determine P or F using P = F(P/F,i,n) or F = P(F/P,i,n), there are
two equivalent methods to determine i and n in the factors.

Method 2.
Find the effective interest rate for the time period of the nominal
rate using effective i formula, Eq. [4.8]



Set n to the number of periods in the nominal rate statement


r
Effective i = (1+ ) 1
m
m

Slide Sets to accompany Blank & Tarquin, Engineering

Economy, 6
th
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Single Amounts: Numerical Example
Using Method 1
+ Find future worth in 5 years if $5000 now earns
interest at 6% per year, compounded monthly.
+ Effective i per month is i = 6%/12 = 0.5%
+ Total number of CP for year and m = 12 times per
year is n = (12)(5) = 60 periods

F = 5000(F/P,0.5%,60) = 5000(1.3489)
= $6744

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-19
Sct 4.6 Equivalence Relations:
Series with PP CP
When cash flows involve a series (A, G, or g)
the PP is defined by the frequency of the cash
flows
IF PP CP
Calculate the effective i per payment period
Apply the correct n for the total number of
payments periods.

Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
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Series: Numerical Example


A = $500 every 6 months
F
7
= ?
PP > CP since PP = 6-months and CP = quarter
Calculate effective i per PP of 6-months
i
6-months
means adjusting r to fit the PP
r = 20% per year, compounded quarterly
0 1 2 3 4 5 6 7 Years
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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4-21
Series: Numerical Example
Adjusting the interest rate
r = 20% per year, compounded quarterly
i/qtr = 0.20/4 = 0.05 = 5% per quarter
2 quarters in the 6-month payment period
Effective i = (1.05)
2
1 = 10.25% per 6-month
Now, the interest matches the payment period
Finding F
year 7
= F
period 14

F = 500(F/A,10.25%,14) = 500(28.4891)
= $14,244.50
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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4-22
Sct 4.7 Single Amounts and
Series with PP < CP
This situation is different from the last where PP
CP
Here, PP is less than the compounding period,
CP
Raises questions of how interperiod
compounding is handled
Study Example 4.10
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
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4-23
Sct 4.8 Effective Interest Rate
for Continuous Compounding
Recall that effective i = (1 + r/m)
m
1
What happens if the compounding frequency, m,
approaches infinity?
This means an infinite number of compounding periods within a
payment period, and
The time between compounding approaches 0
A limiting value of i will be approached for a given value
of r
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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4-24
Derivation of Continuous Compounding
Effective Rate
Rewrite the effective i
relation as
(1 ) 1 1 1
r
m
r
m
r r
m m
(
| |
(
+ = +
|
(
\ .

(1 ) 1
m
r
i
m
= +
Now, examine the impact
of letting m approach
infinity. This requires
taking the limit of the
above expression as
m
Remember the definition
of the number e
1
lim 1 2.71828
h
h
e
h

| |
+ = =
|
\ .
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-25
Derivation of Continuous Compounding
Effective Rate
So that:
lim 1 1 1.
r
m
r
r
m
r
i e
m

(
| |
(
= + =
|
(
\ .

The effective i when interest is compounded
continuously is then:
Effective i = e
r
1
To find the equivalent nominal rate given i when
interest is compounded continuously, apply:
ln(1 ) r i = +
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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4-26
Sct 4.9 Interest Rates That Vary
Over Time
In practice, interest rates do not stay the same
over time unless by contractual obligation.
There can exist variation of interest rates over
time quite normal!
If required, how is this situation handled?
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-27
Varying Rates: Finding the
Present Worth
To find the present worth:
+ Bring each cash flow amount back to the desired
point in time at the interest rate for each period
according to:
P = F
1
(P/F,i
1
,1) + F
2
(P/F,i
1
,1)(P/F,i
2
,1) +
+ F
n
(P/F,i
1
,1)(P/F,i
2
,1)(P/F,i
3
,1)(P/F,i
n
,1)
This process can get computationally involved!
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-28
Varying Rates: Observations
We seldom evaluate problem models with
varying interest rates except in special
cases.
If required, it is best to build a
spreadsheet model
It can be a cumbersome task to perform
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-29
Chapter Summary
Many applications use and apply nominal and
effective compounding
Given a nominal rate must get the interest rate to
match the frequency of the payments
Apply the effective interest rate per payment period
When comparing interest rates over different
payment and compounding periods, must calculate
the effective i to correctly compare P, F or A values
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
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4-30
Chapter Summary - continued
All time value of money interest factors
require use of an effective (true) periodic
interest rate
The interest rate, i, and the payment or cash
flow periods must have the same time unit
One may encounter varying interest rates.
An exact answer requires a sequence of
interest rates for each period
Slide Sets to accompany Blank & Tarquin, Engineering
Economy, 6
th
Edition, 2005
2005 by McGraw-Hill, New York, N.Y All Rights Reserved
4-31
Chapter 4

End of Slide Set