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MS-291: Engineering Economy

(3 Credit Hours)

ARITHMETIC GRADIENT

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Arithmetic Gradient Factors

(P/G, A/G)
Cash flows that increase or decrease by a constant amount
are considered arithmetic gradient cash flows.
The amount of increase (or decrease) is called the gradient
$2000
$1500

$175
$125
$100

$150

$500

G = $25
Base = $100

Cash Flow Formula

$1000

G = -$500
Base = $2000

Gradient
series
could be
both: cash
inflow (as
given
here) or
Outflows

CFn = base amount + (n-1)G

Arithmetic Gradient Factors

(P/G, A/G)

When we have a Gradient Series we

cannot apply Single Amount Present
Worth/Future Worth factors or Uniform
Series factors
We have to use a different methodology to
address problems related to gradient cash
flows.

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Solving Arithmetic Gradient

related problems
Present value of the Arithmetic Gradient series can be
calculated as follows:
1. Find the gradient and base
2. Cash flow diagram maybe helpful if you draw it
3. Break the gradient series into a Uniform series and a
Gradient Series as shown on next slide
4. The formula for calculating present value of the
Arithmetic Gradient series is as follows;

PT =

PA

PG

5. Calculate PA and PG and use the above formula to

get the present value of the Arithmetic Gradient

Arithmetic Gradient Factors

(P/G, A/G)
The base amount is A and the Gradient is G in the
following graph
CFn = base amount + (n-1)G

Cash Flow Formula

Important!!!
PG series start
with year 2

A+(n-1) G
A+3G

(n-1)G
3G

A+2G
A+G

=
0

+
0

PT =

2G

PA

PG

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Arithmetic Gradient Factors

(P/G, A/G)
PT =

PA

PG

PA = A(P/A, i, n) or Uniform Series Present worth

Factor
PG = G(P/G, i, n) or Arithmetic Gradient Present
Worth Factor you can use table for it too.
Alternatively, PG can also be calculated by
following formula
G (1 i ) n 1
n
PG

i i (1 i ) n
(
1

i)n

PG

Or

G (1 i ) n in 1

i
i 2 (1 i ) n

Arithmetic Gradient Factors

(P/G, A/G)
Equivalent cash flows:
$175
$150
$125
$100

$100

$50
$25

=>

0
0

G = $25

PA

$P = $100(P/A,i,4) + $25(P/G,i,4)

Note: the gradient series

(PG) by convention starts
in year 2.

Note: Annuity series (PA)

starts from year 1.

Base = $100

PT =

$75

PG
PG

G (1 i )n 1
n

i i (1 i )n
(1 i )n

Where PA = Present worth uniform series (P/A, i,n) and PG = present worth of the gradient series (P/G,i, n)

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Example (Problem 2.25)

Profits from recycling paper, cardboard, aluminium,
and glass at a liberal arts college have increased at a
constant rate of $1100 in each of the last 3 years.
If this years profit (end of year 1) is expected to be
$6000 and the profit trend continues through year 5,
(a) what will the profit be at the end of year 5 and
(b) what is the present worth of the profit at an interest
rate of 8% per year?

G = $1100,

Base = $6000

Example (Problem 2.25)

(a)
(b)

what will the profit be at the end of year 5 &

what is the present worth of the profit at an interest rate of 8% per
year?

G = $1100

Base = $6000
$10400
$9300

$8200

$1100

1 2

=>

$7100
$6000
0

$4400
$3300
$2200

$6000

Find the cash flows as follows:

CF = Base + G(n-1)
CF1 = 6000 + 1100(1-1)= 6000
CF2 = 6000 + 1100(2-1)= 7100
CF3 = 6000 + 1100(3-1)= 8200
CF4 = 6000 + 1100(4-1)= 9300
CF5 = 6000 + 1100(5-1)= 10400

PT =
PA
P = A(P/A, i, n)
P = 6000(P/A, 8%, 5)

P=

6000(3.9927)

P = 32066

+
PG
G(P/G, i, n)

+
+ 1100(P/G, 8%, 5)
+ 1100(7.3724)

4 5

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Practice Question: 5 minutes

Neighboring parishes in Louisiana have agreed to pool
road tax resources already designated for bridge
refurbishment. At a recent meeting, the engineers
estimated that a total of $500,000 will be deposited at
the end of next year into an account for the repair of
old and safety-questionable bridges throughout the area.
Further, they estimate that the deposits will increase
by $100,000 per year for only 9 year thereafter, then
cease. Determine the equivalent: present worth, if public
funds earn at a rate of 5% per year.
5%

Uniform Series Factors

Athematic Gradient

Sinking
Fund
(A/F)

Compound
Amount
(F/A)

Capital
Recovery
(A/P)

Present Gradient
Worth
Present Worth
(P/A)
(P/G)

Gradient
Uniform
Series (A/G)

0.09069

11.0266

0.14069

7.1078

26.1268

3.6758

10

0.07950

12.5779.

0.12950

7.7217

31.6520

4.0991

Solution

Base = 500,000
Gradient = 100,000
Taking units in 1000
Base = 500
Gradient =100
i= 5%
n=1+9 = 10

PT =
PT

0 1

PA

PG

= 500(P/A,5%,10) + 100(P/G,5%,10)
= 500(7.7217)
+ 100(31.6520)
=$7026.05 or .. ($7,026,050)
2

10

$500
$600
$700

$800
$900
$1000

$1100

$1200

$1300
$1400

P=?

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. What about A/G or F/G?

Arithmetic Gradient Uniform

Series Factor (A/G)
Similar procedure as done for Arithmetic Gradient Present
worth Factor
Following formula:

AT =

AA

AG

AA = A (Annual Worth) Given as base value of G series and AG = G(A/G, i, n)

AG can be get from
factor tables or through
given formula in box

(1 + ) 1

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Using Factor Tables

Example: A/G factor

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Example: A/G Factor

Neighboring parishes in Louisiana have agreed to pool
road tax resources already designated for bridge
refurbishment. At a recent meeting, the engineers
estimated that a total of $500,000 will be deposited at
the end of next year into an account for the repair of
old and safety-questionable bridges throughout the area.
Further, they estimate that the deposits will increase
by $100,000 per year for only 9 year thereafter, then
cease.
Determine the equivalent: Annual series amount, if
public funds earn at a rate of 5% per year.

Solution

AT =

Base = 500,000
Gradient = 100,000
Taking units in 1000
Base = 500
Gradient =100
i= 5%
n=1+9 = 10

AT

AA

AG

= 500 + 100(A/G,5%,10)
= 500 + 100(4.0991)
=$909.91 or .. ($909,910)
2

10

$500
$600
$700

$800
$900
$1000

$1100

$1200

$1300
$1400

A= $909,910

10

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Arithmetic Gradient Future

Worth Factor (F/G)
Another factor in Gradient family is Future worth
of an Arithmetic Gradient series (F/G)
It can be obtained by multiply (P/G) and (F/P) factors
/

1 (1 + ) 1

No factor table values is available so only formula can be use for calculating F/G factor

Note: To get future value of Arithmetic Gradient . We do not need to

divide the gradient into two separate cash flows like Present worth of
Arithmetic gradient series. This F/G will be the future value of entire
gradient series.

Final Words about Arithmetic

Gradient
Present Worth(PW) or Annual Worth(AW) of Arithmetic Gradient (P/G
or A/G)
. Base and Gradient considered separately for both P/G and A/G
. Get Two series a PA/AA series and one PG/AG series
.use the factor tables to get values for P A/AA & PG/AG
Add both to get PT/AT.

Future worth of Arithmetic Gradient (F/G)

Base and Gradient are not considered separately
. No factor values are available so have to relay on formula
.formula directly calculate the future worth of Arithmetic Gradient

1 (1 + ) 1

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Geometric Gradient Factors

(Pg /A)
A Geometric gradient is when the periodic payment is
increasing (decreasing) by a constant percentage:
the rate at which the cash flow is increasing is g
The initial amount of Geometric Gradient is A1
Pg is the present worth of entire Gradient Series including A1
It is important to note that Initial amount is not considered
separately while working with Geometric Gradient

for g = i:

for g i:
1+
1 1+

1+

Note: If g is negative, change signs in front of both g values

Geometric Gradient Factors

(Pg /A)
A Geometric gradient is when the periodic payment is
increasing (decreasing) by a constant percentage: A (1+g)n-1
1
A1 = $100, g = 10% or 0.1
A2 = $100(1+g)
A (1+g)2
A1 (1+g) 1
A3 = $100(1+g)2
A1

An = $100(1+g)n-1
where: A1 = cash flow in period 1 and g = rate of increase

for g = i:
=

4 n

It maybe noted that A1

is not considered
separately in geometric
gradients

for g i:
1+
1 1+

1+

Note: If g is negative, change signs in front of both g values

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Future Worth (F/G) and Annuity

(A/G) from Geometric Gradient
Series
We just learned how to get Present Value of a
Geometric Gradient
We can first derive the Present Worth of the Geometric
Gradient and then can use F/P factor for
calculating future value of a geometric gradient
Similarly, A/P factor can be applied to P/G factor to
calculate the Annual worth/Annuity series from
Geometric Gradient

Class Practice: 4 Minutes

Determine the present worth of a geometric

gradient series with a cash flow of $50,000 in
year 1 and increases of 6% each year
through year 8. The interest rate is 10% per
year.
for g i:
=

1+
1 1+

for g = i:
=

1+

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Class Practice: 4 Minutes

Determine the present worth of a geometric

gradient series with a cash flow of $50,000 in
year 1 and increases of 6% each year
through year 8. The interest rate is 10% per
year.
n

1 1 g

1 i
Pg A
ig

1 1 0 .6

50000 1 0 .10
0 .10 0 .06

0 .257
50 ,000

0 .04

1 0 .743
50 ,000

0 .04

50 ,000 ( 6 .425 )

$ 321 , 250

Summary of all
Factors!!!

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Single payment Factors

F=?

F/P Factor
F= P(F/P, i%, n)
n and i is given

P is given

P/F Factor
P =?

P= F(P/F, i%, n)

n and i is given

F = given

Uniform Series Factors

P/A Factor
P = A(P/A, i%, n)

A/P Factor
A = P(A/P, i%, n)

F/A Factor
F = A(F/A, i%, n)

A/F Factor
A = F(A/F, i%, n)

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Athematic Gradient
FG = ?

F = PT(F/P, i%, n)
or
PA = A(P/A, i%, n)
PG = G(P/G, i%, n)

1 (1 + ) 1

Athematic Gradient

A = PT(A/P, i%, n)
or
AT =

PA = A(P/A, i%, n)
PG = G(P/G, i%, n)

AA

AG

AA = A (Annual Worth) &

AG = G(A/G, i, n)

(1 + ) 1

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Geometric Gradient
Fg = ?
Pg = ?

for g i:
=

1+
1 1+

F = Pg(F/P, i%, n)
Similarly

for g = i:
=

1+

A = Pg(A/P, i%, n)

Chapter 3
Combining Factors
and Spreadsheet
Functions

Engineering Economy

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This Chapter Objectives

1. Shifted uniform series
2. Shifted series and single cash flows
3. Shifted gradients

Example
0

P=?

10

11

A = $50
P3 = ?

12

13

Year

How can we get Present worth of this series ?

Use the P/F factor to find the present worth of each disbursement at year 0 and add
them.
Use the F/P factor to find the future worth of each disbursement in year 13, add
them, and then find the present worth of the total, using P/F= F( P/F, i ,13).
Use the F/A factor to find the future amount F/A =A( F/A, i ,10), and then compute
the present worth, using P/F=F(P/F, i ,13).
Use the P/A factor to compute the present worth P3 =A( P/A , i ,10) (which will be
located in year 3, not year 0), and then find the present worth in year 0 by using the
(P/F , i ,3) factor.

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Shifted Uniform Series

Typically the last method is used for calculating the present worth
of a uniform series that does not begin at the end of period 1.
Note that a P value is always located 1 year or period prior to the
beginning of the first series amount. Why? Because the P/A factor
was derived with P in time period 0 and A beginning at the end of
period 1.
The most common mistake made in working problems of this type
is improper placement of P .
Remember:
When using P/A or A/P factor, PA is always one year ahead of first A
When using F/A or A/F factor, FA is in same year as last A
The number of periods n in the P/A or F/A factor is equal to the number of uniform
series values

PA is always one year ahead

of first A
0

10

11

12

13

Year

A = $50
P3 = ?
FA is in same year as last A
0

A = $50
The number of periods n in the P/A or
F/A factor is equal to the number of
uniform series values

10

11

12

13

F=?

Year

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Steps for applying factors to

Shifted Cash Flows
1. Draw a diagram of the positive and negative cash flows.
2. Locate the present worth or future worth of each series on
the cash flow diagram.
3. Determine n for each series by renumbering the cash flow
diagram.
4. Draw another cash flow diagram representing the desired
equivalent cash flow. (Optional)
5. Set up and solve the equations.

Example
The offshore design group at Bechtel just purchased
upgraded CAD software for $5000 now and annual
payments of $500 per year for 6 years starting 3 years
from now for annual upgrades. What is the present
worth in year 0 of the payments if the interest rate is
8% per year?
Solution 1.

Draw a diagram of the positive and negative cash flows.

2. Locate the present
worth or future worth of
each series on the cash
flow diagram.

i= 8% per year
0

2
0

PA = ?
PT = ?

PA = ?

P0 = $5000

3
1

4
2

5
3

6
4

A = $500

7
5

8 Year
n
6
3. Determine n for each
series by renumbering the
cash flow diagram.

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P' A = $500( P /A ,8%,6)

5. Set up
and solve
the
equations.

P = P' ( P /F ,8%, 2)
P = $500( P /A ,8%,6) ( P /F ,8%, 2)
A

PT = P0 +PA
=5000 + 500( P /A ,8%,6)( P / F ,8%,2)
=5000 +500(4.6229)(0.8573)
$6981.60

Class Practice 5 Minutes Time

Calculate the present worth of the cash flow shown below at i = 10%
i = 10%
0

Actual year

A = $10,000

10%

Single Payments

Uniform Series Factors

Compoun
d Amount
(F/P)

Present
Worth
(P/F)

Sinking
Fund
(A/F)

Compound Capital
Amount
Recovery
(F/A)
(A/P)

Present
Worth
(P/A)

1.1000

0.9091

1.00000 1.0000

1.10000

0.9091

1.6105

0.6209

0.16380 6.1051

0.26380

3.7908

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Class Practice 5 Minutes Time

Calculate the present worth of the cash flow shown below at i = 10%

i = 10%
0

PT = ?

PA = ?

Actual year
Series year

A = $10,000

Solution
(1) Use P/A factor with n = 5 (for 5 arrows) to get PA in year 1

---- A(P/A,10%, 5)

(2) Use P/F factor with n = 1 to move PA back for PT in year 0

---- (P/F,10%, 1)

PT = A(P/A,10%, 5) (P/F,10%,1)
= 10,000(3.7908)(0.9091)
$34462

Shifted Series and Random

Single Amounts
For cash flows that include uniform series and randomly placed
single amounts:
Uniform series procedures are applied to the series amounts
Single amount formulas are applied to the one-time cash flows
The resulting values are then combined per the problem statement

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Example
Find the present worth in year 0 for the cash flows shown using an interest
rate of 10% per year.
i = 10%
0

10

A = $5000

Solution:

$2000
i = 10%
0

Actual year

8
6

10

Series year

A = $5000

PT = ?

$2000

Find the cash flows both positive and negatives

Locate the present worth/ future worth
Determine the n by re-numbering the cash flows series

Uniform series procedures are applied to the series amounts. Single amount
formulas are applied to the one-time cash flows

The resulting values are then combined per the problem statement

Example:

PT = ?

PA = ?

Use P/A to get PA in year 2: PA = 5000(P/A,10%,8) = 5000(5.3349) = $26,675

Move PA back to year 0 using P/F: P0 = 26,675(P/F,10%,2) = 26,675(0.8264) = $22,044
Move $2000 single amount back to year 0: P2000 = 2000(P/F,10%,8) = 2000(0.4665) = $933

Now, add P0 and P2000 to get PT: PT = 22,044 + 933 = $22,977

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Class Practice: 8 Minutes

An engineering company lease the mineral rights to a mining
company on its land. The engineering company makes a
proposal to the mining company that it pay $20,000 per year for
20 years beginning 1 year from now, plus $10,000 six years from
now and $15,000 sixteen years from now. If the mining company
wants to pay off its lease immediately, how much should it pay
now if the investment is to make 16% per year?
Single Payments

16%

Uniform Series Factors

Compound
Amount (F/P)

Present Worth
(P/F)

Capital
Recovery (A/P)

Present Worth
(P/A)

2.4364

0.4104

0.27139

3.6847

2.8262

0.3538

0.24761

4.0386

16

10.7480

0.0930

0.17641

5.6685

17

12.4677

0.0802

0.17395

5.7487

20

19.4608

0.0514

0.16867

5.9228

Solution

16

17

18

19

20

A =$20,000

P=?

$10,000

$15,000

P = 20,000(P/A ,16%,20)+
10,000( P /F ,16%,6) +
15,000(P/F,16%,16)
P = $20,000(5.9288)+ $ 10,000( 0.4104) + $ 15,000(0.0930)
= $124,075

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Shifted Gradient Series

We already learnt how to get P (Present
value) or A ( Annuity or a Uniform series)
from a Gradient Series
We will now discuss how to calculate P or
A from Shifted Gradient Series a
gradient series not starting from year 1.

P from Shifted Gradient Series

P from Normal Arithmetic Gradient Series

Shifted Arithmetic gradient Series

PT = ?

PA = A(P/A, i%, n)
PG = G(P/G, i%, n)
PA = ?

PG = ?

Shifted gradient begins at a

time other than between periods
1 and 2
Must use multiple factors to find PT
in actual year 0

PG = ?

Present worth PG is located 2

periods before gradient starts
P T =P A +P G
=100(P/A , i ,8) + 50(P/G, i ,5)(P/F, i ,3)

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What will be the procedure for calculating P from

Shifted Geometric Gradient Series?
Lets discuss it directly from a Numerical Example

Example:
Shifted Geometric Gradient
Weirton Steel signed a 5-year contract to purchase water treatment chemicals from a
local distributor for $7000 per year. When the contract ends, the cost of the chemicals is
expected to increase by 12% per year for the next 8 years. If an initial investment in
storage tanks is $35,000, determine the equivalent present worth in year 0 of all of the
cash flows at i = 15% per year.
Pg = ?

PT = ?
0 1

3 4

5 6 7 8
0

$7000

i =15% per year

1 2 3

9 10 11 12 13
4

5 6

7 8

$7840

$35000

$17331
12% increase
per year

Year
Geometric
Gradient n

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P from Shifted Gradient Series

PT = 35,000 + A ( P /A ,15%, 4) + A1 ( P/A ,12%,15%,9) (P/F ,15%,4)

PT = 35,000 + 7000 ( 2.8550) + 7000

$83,232

.
.

(0.5718)

A from Shifted Gradient Series

Shifted gradient Series

A (Annuity or Uniform Series)

To calculate A for shifted Gradient Series (Arithmetic or

Geometric), there are several possibilities.
The easiest way (and recommended also) is to get the P of
shifted Gradient Series first (procedure just explained in pervious slides) then
use A/P factor to get A for the shifted gradient series
A, for above example will be: A = PT (A/PT, i%, n),
where PT refers to the present value of the shifted gradient series that procedure is
already explained on pervious slide.

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Important Points for P and A

of Shifted Gradient Series
Must use multiple factors to find P in actual year 0, for shifted
gradient series
The present worth (P) of an arithmetic gradient will always be
located two periods before the gradient starts.
To find the equivalent A series of a shifted gradient through
all the n periods, first find the present worth of the gradient at
actual time 0, then apply the (A/P, i, n) factor.
F from gradient series can also be find by first calculating P
and then using F/P factor

Solution
For the cash flows shown, find the future value in year 7 at i = 10% per year

i = 10%
Set up the
equations
only

1
0

PG = ?

2
1

PG

3
2

4
3

600
700

5
4

550

6
5
500

Actual years

7
6

Gradient years

450

650

F=?

G = $-50

Solution:

PG is located in gradient year 0 (actual year 1); base amount of $700 is in gradient years 1-6

PG = A(P/A,10%,6) G(P/G,10%,6)
PG = 700(P/A,10%,6) 50(P/G,10%,6) = 700(4.3553) 50(9.6842) = $2565
PG= PG(F/P,10%,1) = 2565(0.9091) = $2331.84

F = PG(F/P,10%,7) = 2331.84(1.9487) = $4544

Method 1

F = PG(F/P,10%,6) = 2565(1.7716) = $4544

Method 2

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Using Single Amount factors (Correct

but not Standard methods)
Method 3

Method 4

So for .
1. Introduction

What is Economics? Economics for Engineers ?

What is Engineering Economy ? Performing Engineering Economy
Study ?
Some Basic Concepts Utility & Various cost concept, Time value of
money (TVM), Interest rate and Rate of Returns, Cash Flow, Economic
Equivalence, Minimum Attractive Rate of Return, Cost of Capital and
MARR, Simple and compound interest rates

2. Various Type of Factors

Factors Single payment Factors
P/F, F/P
Uniform Series Factors
P/A, A/P, F/A, A/F
Gradient Series Factors
Arithmetic Gradient and Geometric Gradient

3. Dealing with Shifted Series

Shifted uniform series

Shifted series and single cash flows
Shifted gradients

These were three

Foundational
Pillars we need
for using various
engineering
economy criteria
for decision
making

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Lets go for the Final

foundational pillar before
studying formal engineering
economy EVAUALTING criteria
of decision making

Chapter 4
Nominal and Effective
Interest Rates
MS291: Engineering Economy

Course Instructor: Dr. Muhammad Sabir

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Content of the Chapter

Interest Rate: important terminologies

Nominal and Effective Rate of Interest
Effective Annual Interest Rate
Converting Nominal rate into Effective Rate
Calculating Effective Interest rates
Equivalence Relations: PP and CP
Continuous Compounding
Varying Interest Rates

Lets start with a

Simple Example

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15% per year

Compounded daily

How much
you going to
pay after 1
year ?

But ..is Due amount

after a year is really
$1150 ? Lets do
check!!!

Paid $1000 from credit card

1000+150 = $1150 ?

Rate is 15% per year but compounding is daily so the rate at per day is 0.15/365 =
0.000411 per day or 0.0411% per day
Days
1

Amount ($)
1000

Interest earned

Total due ($)

Amount x r =0.411

1000.411

1000.411

0.411169

1000. 82269

1000. 82269

0.411169

1001.233507

--------

------

------

1161.338553

0.47731

1161.815863

365

1161.815863 ..
But this is around
16.81% rate rather
than 15% stated
Lets Continue on
next slide

Interest rate is same

for each period
1161.815863 . But this is
around 16.81% rate rather
than 15% stated
Nominal Interest Rate (15%)

denoted by (r)
does not include any consideration of
the compounding of
interest(frequency)
It is given as: r = interest rate per
period x number of compounding
periods

But interest due is

increasing in every
period

Effective Interest Rate (16.81%)

Denoted by (i)
take accounts of the effect of the
compounding period
commonly express on an annual
basis (however any time maybe
used)

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Previous Learning

Our learning so for is based one interest rate thats

compounded annually

Interest rates on loans, mortgages, bonds & stocks are

commonly based upon interest rates compounded more
frequently than annually

When amount is compounded more than once annually,

distinction need to be made between nominal and
effective rate of interests

Interest Rate:
important terminologies
New time-based definitions to understand and remember
Interest period (t) period of time over which interest is expressed.
For example, 1% per month.
Compounding period (CP) The time unit over which interest is charged or earned.
For example,10% per year, here CP is a year.
Compounding frequency (m) Number of times compounding occurs within the
interest period t.
For example, at i = 10% per year, compounded monthly, interest would be
compounded 12 times during the one year interest period.

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Examples of interest rate

Statements
Annual interest rate of 8% compounded monthly
interest period (t) = 1 year
compounding period (CP) = 1 month
compounding frequency (m) = 12
Annual interest rate of 6% compounded weekly
interest period (t) = 1 year
compounding period (CP) = 1 Week
compounding frequency (m) = 52

IMPORTANT: Compounding
Period and Interest Rate
Some times, Compounding period is not mentioned in
Interest statement
For example, an interest rate of 1.5% per month
..It means that interest is compounded each
month; i.e., Compounding Period is 1 month.
REMEMBER: If the Compounding Period is not
mentioned it is understood to be the same as the time
period mentioned with the interest rate.

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Calculating Effective
Interest Rate
Effective interest rate per compounding
period can be calculated as follows:
=

Example:
Three different bank loan rates for electric
generation equipment are listed below.
Determine the effective rate on the basis of the
compounding period for each rate
(a) 9% per year, compounded quarterly
(b) 9% per year, compounded monthly
(c) 4.5% per 6 months, compounded weekly

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Example: Calculating
Effective Interest rates per CP
a. 9% per year, compounded quarterly.
b. 9% per year, compounded monthly.
c. 4.5% per 6 months, compounded weekly.

Class Practice 1:
For nominal interest rate of 18% per year
calculate the effective interest rate
i. If compounding period is yearly 18%
ii. If compounding period is semi-annually
iii. If compounding period is quarterly 4.5%
iv. If compounding period is monthly 1.5%
v. If compounding period is weekly 0.346%
vi. If compounding period is daily 0.0493 %

9%

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Effective Annual Interest

Rates
When we talk about Annual we consider year as the
interest period t , and the compounding period CP can be
any time unit less than 1 year
Nominal rates are converted into Effective Annual Interest Rates (EAIR)
via the equation:

= (1 + ) 1

where
ia = effective annual interest rate
i = effective rate for one compounding period (r/m)
m = number times interest is compounded per year

= (1 +

) 1

Effective Interest Rate for any

time period

r = 18% per year,

compounded CP-ly

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Example
For a nominal interest rate of 12% per year, determine the nominal and effective
rates per year for
(a) quarterly, and
ia = (1 + i)m 1
(b) monthly compounding
Solution:
(a) Nominal r per year = 12% per year

where
ia = effective annual interest rate
i = effective rate for one compounding
period (r/m)
m = number times interest is compounded
per year

Nominal r per quarter = 12/4 = 3.0% per quarter

Effective i per year = (1 + 0.03)4 1 = 12.55% per year
(b) Nominal r per month = 12/12 = 1.0% per month
Effective I per year = (1 + 0.01)12 1 = 12.68% per year

15% per year

Compounded daily

Effective I per year = (1 + 0.15/365)365 1 = 16.81% per year

Economic Equivalence:
From Chapter 1

Different sums of money at different times may be equal

in economic value at a given rate
$110
Rate of return = 10% per year
Year

1
$100 now

$100 now is economically equivalent to $110 one year from

now, if the $100 is invested at a rate of 10% per year
Economic Equivalence: Combination of interest rate (rate of return) and
time value of money to determine different amounts of money at different
points in time that are economically equivalent ..
Compounding/Discounting (F/P, P/F, F/A, P/G etc.)

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Equivalence Relations: Payment

Period(PP) & Compounding
Period(CP)

The payment period (PP) is the length of time

between cash flows (inflows or outflows)
Assume the monthly payments as shown below

E.g., r = nominal 8% per year, compounded semi-annually

CP
6 months

PP
1 month

CP
6 months

10

11

12

Months

PP = CP, PP >CP, or PP<CP

Equivalence Relations: Payment

Period(PP) and Compounding Period

It is common that the lengths of the payment period and the

compounding period (CP) do not coincide

To do correct calculation of Economic Equivalence

Interest rate must coincide with compounding period

It is important to determine if PP = CP, PP >CP, or PP<CP

Length of Time

Involves Single
Amount
(P and F Only)

PP = CP
PP > CP
PP < CP

P/F , F/P
P/F, F/P

Involves Gradient
Series (A, G, or g)

P/A, P/G, P/g

F/A etc.
P/A, P/G, F/A etc.

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Thank You