Engineering Economy

Chapter 3
Fall 2018

Dr. Ako Rashed Hama

 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

frequent interest rates & cash flows ≡ payments more than once a year
Interest rates for less than a year >>> nominal and effective

1. Interest period (t):

period of time over which interest is expressed; 1% per month
2. Compounding Period (CP):
time unit between points when interest is computed (charged or earned)
and added to the initial amount; 10% per year compounded monthly
3. Compounding frequency (m):
number of times compounding occurs within the interest period t;
i = 10%/year, compounded monthly ≡ interest is compounded 12
4. Nominal interest rate (r): times/year
simplified expression of the annual cost of money
interest rate per time period without regard to compounding period
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

4. Nominal interest rate (r):

r = interest rate per period x number of periods [3.1]
interest rate of 1.5% per month:
nominal interest rate r = 4.5% per quarter = 1.5% per period x 3 periods
or 9% per semiannual period = 1.5% x 6, or 18% / year, or 36% / 2 years
nominal interest rates are essentially simple interest rates
never can be used in interest (factor) formulas!
5. Effective rate (i):
converting nominal interest rate by compounding period & payment period
Effective rate for any time period:
i per period = (1 + r/m)m – 1 [3.2]
Spreadsheet function = EFFECT(r%,m)
Effective annual rate:
ia = (1 + i)m – 1
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Nominal & Effective Interest Rates Statements:

Nominal rates Effective rates

• compounding period is given & it • compounding period is not given
is shorter than interest period • compounding & rate are stated
• rate is stated nominal effective

 8% per year compounded  15% per year

monthly  effective 8.3% per year
 2% per month compounded compounded monthly
weekly
 2% per month compounded
 8% per year compounded monthly
quarterly
 5% per quarter compounded  effective 1% per week
monthly compounded continuously
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Nominal & Effective Interest Rates Statements:

compounding period for time period

m must equal
frequency effective i for r

annual annual year 1

semiannual annual year 2
quarterly annual year 4
monthly annual year 12
daily annual year 365
monthly semiannual 6 months 6
weekly quarterly quarter 12
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Example 1
Nominal Effective
r = rate/period × periods i per period = (1 + r/m)m – 1

Q1. Rate is 1.5% per month. Q2. Credit card rate is 1.5% per month
Determine nominal rate per compounded monthly. Determine effective
quarter, year, and over 2 years. rate per quarter and per year.

qtr: r = 1.5% × 3 mth = 4.5% period is quarter:

r = 1.5 × 3 mth = 4.5% , m = 3
year: r = 1.5% × 12 mth = 18% i = (1 + 0.045/3)3 – 1 = 4.57% per quarter
= 4.5% × 4 qtr = 18%
period is year:
2 yrs: r = 1.5% × 24 mth = 36% r = 1.5% x 12 mth = 18% , m = 12
= 18% × 2 yrs = 36% i = (1 + 0.18/12)12 – 1 = 19.6% per year
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Example 2

a. first r from Eq. [3.1], then finding i from Eq. [3.2] with m=6:

b. r from Eq. [3.1] = 3.5% x 2 = 7%

i from Eq. [3.2] with m=2 (2xq = 1semi) and m=4 (4xq = 1an):
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Example 3
For a nominal interest rate of 12% per year, determine the nominal and
effective rates per year for (a) quarterly, and (b) monthly compounding.

Effective annual rate:

ia = (1 + i)m – 1

(a) Nominal r / year = 12% per year

Nominal r / quarter = 12/4 = 3.0% per quarter
Effective i / year = (1 + 0.03)4 – 1 = 12.55% per year

(b) Nominal r / month = 12/12 = 1.0% per month

Effective i / year = (1 + 0.01)12 – 1 = 12.68% per year
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

6. Effective continues interest rate:

frequent compounding >>> shorter compounding period ≡ m → ∞
i = er – 1 [3.3]
time period i = time period r & Euler’s number e = ln-1(1)= 2.7182
Example 4

a. r = 18% / 12 = 1.5% per month

b. taking ln from Eq. [3.3]

 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Using Excel functions to find rates

 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

9. Payment Period (PP):

shortest time (length) between payments (cash flows)
interest is earned on payment money once per period (cost of money)

Compounding Period (CP):

how often interest in
compounded

Payment Period (PP):

how often cash flows occur r = 0.5% per month

ALWAYS:
1) compare CP and PP: CP = PP, PP ≥ CP, CP > PP
2) find cash flows type: single amount (P & F), uniform or gradients series (A, G, g)
3) find correct effective i and n (both having the same time unit!)
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

10. Equivalence for Single/Series Payments when PP ≥ CP:

P = F (P/F, effective i per period, # of periods) [3.4]
F = P (F/P, effective i per period, # of periods) [3.5]

r = 12% per year

compounded monthly
i = (1+r/m)m-1
Example 5
Find equivalent F in 10 years if P is $1,000 now. Assume r = 12% per year
compounded semi-annually.

PP = year ; CP = 6 months; period = 6 months, single amount cash flows

i = 1% x 6 = 6% per semi, n = 10 years x 2 CP per year = 20 semi
From page 398 and Eq. [3.5] or (Excel):
F = 1,000 (F/P, 6% semi, 20 semi) = 1,000 (3.2071) = $3,207.14
Alternative: calculating annual and using Excel:
i = (1+0.12/2)2 -1 = 0.1236 = 12.36% per year, n = 10 year
F = 1,000 (F/P, 12.36% annually, 10 years) = 1,000 (3.20714) = $3,207.14
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Example 6

 PP = year > CP = 6 months; n = 10

r = 8%  single amount cash flows for P
 uniform series cash flows for A
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Example 6
Since PP > CP then:
First: finding effective i per year for all Ps, and
converting all cash flows to one P at time 0
Next: finding effective i for semiannual, and
calculating A over 20 semiannual periods
First:

Next:
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

11. Equivalence for Single/Series Payments when CP > PP:

interperiod cash flows earn no interest
or
interperiod cash flows earn compound interest

Usually:
interest is not paid on interperiod deposits

Equivalence computations:
Cash flows are moved to match CP time period
Move cash flows not at end of a compounding period:
 Deposits (minus cash flows) - to end of compounding period
 Withdrawals (plus cash flows) - to beginning of same period
(which is the end of last period)
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Example 7
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Example 7
Qtr 1 Qtr 2 Qtr 3 Qtr4
 Engineering Economy
Chap 3: Nominal and Effective Interest Rates

Example 7

1unit = $1000
moving cashflows: from no interperiod interest to PP = CP = 1 quarter
ia = 12% per year & iq = 12%/4 = 3% per quarter
5 single payments F/P over 4 quarters, n = 4, 3, 2, 1, 0

$-357,592 by the end of the year