10/9/19

Special Lesson on Interest Rates Example 1 (Quick ad before proceeding to PP & CP)
- If you can recall, most problems we have worked on have the Given the rate, 1 % compounded monthly, what is the semi-annual
payment period equal to compounding period (e.g. annual payments, effective rate?
compounded annually or semiannual payments, compounded
annually or annual payments compounded). That to say is, relatively,
simple. Hence, in this lesson we will tackle about how to handle the
the following cases:
a. PP > CP
b. PP < CP

Method A Method B
1) Convert the nominal rate to a semiannual basis, then determine m 1) Convert the nominal rate to a monthly basis, then determine m
(semiannual basis): (monthly basis):
0.01 0.01 1
rsemi = rann = = 0.005 per semiannual rmo = rann
12 = 12 = 1200 per month
2 2
m = 6 (6 months per semiannual) m = 6 (6 months in a semiannual)

r m 2) Get semiannual effective rate, use the formula:

2) Apply to the formula: i = 1+ −1 isemi = 1+rmo m − 1
m
0.005 6 1 0
isemi = 1+ 1200 − 1
i = 1+ −1
6
i = 0.005010428248 per semiannual isemi = 0.005010428248 per semiannual

Method A
Example 2 (Quick ad before proceeding to PP & CP)
1) Convert the nominal rate to a quarterly basis, then determine m
An interest rate of 8% per 6 months, compounded monthly, is (quarterly basis):
equivalent to what effective rate per quarter? r 0.08
rquart = = = 0.04 per quarter
2 2
m = 3 (3 months per quarter)

r m
2) Apply to the formula: i = 1+ −1
m
0.04 3
i = 1+ −1
3
i = 0.04053557037 per quarter

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Method B Example 3 PP > CP

1) Convert the nominal rate to a monthly basis, then determine m
(monthly basis): For the past 7 years, Excelon Energy has paid $500 every 6 months for a
0.16 1 software maintenance contract. What is the equivalent total amount
rmo = rann
12 = 12 = 75 per month after the last payment, if these funds are taken from a pool that has
m = 3 (3 months in a quarter) been returning 8% per year, compounded quarterly?

2) Get quarterly effective rate, use the formula:

i = 1+rmo m − 1
1 5
i = 1+ 75 − 1
i = 0.04053557037 per quarter

How to solve this problem? Solution

1. Find the effective i per payment period. PP = 6 months
r 0.08
Rule: The interest rate must match the payment period. r6mos = =
2 2
= 0.04 per 6 months
m = 2 (2 quarters per semiannual)
r m 6 .6 7 8
Adjust the interest period to match the payment period i = 1+ − 1 = 1+ − 1 = 0.0404 effective interest per 6 months
m 2

2. Determine n as the total number of payment periods. n = 14 (2 x 7 years)

(1+i)n −1
F=A
i
(1+0.0404)14 -1
F = 500
0.0404
F = $ 9,171.09

Example 4 (Seatwork no. 5) PP<CP Example 5 (Quiz no. 6) PP<CP

What is the future worth of ₱600 deposited at the end of every month What is the present worth of ₱500 deposited at the end of every three
for 4 years if the interest rate is 12% compounded quarterly? months for six years if the interest rate is 12% compounded semi-
annually?

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Uniform Arithmetic Gradient

- An arithmetic gradient series is a cash flow series that either
increases or decreases by a constant amount each period
- The amount of change is called the gradient.
- For example, if an engineer predicts that the cost of maintaining a =
machine will increase by $250 per year until the machine is retired, a
gradient series is involved and the amount of the gradient is $250.

Total Present Worth including base amount

PT = PA ± PG

where: PA is the present worth of the uniform series only

PG is the present worth of the gradient series only

Finding P given G Finding A given G

PG = G (1+i)-2 + 2G (1+i)-3 + 3G (1+i)-4 + … + (n-1)G (1+i)-(n-1)
=
G (1+i)n−1 n
PG = −
i i(1+i)n (1+i)n

1 n
AG = G −
i (1+i)n <=

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Finding F given G Example 1

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
G (1+i)n−1 deposited at the end of next year into an account for the repair of old
FG = −n
i i and safety-questionable bridges throughout the area. Further, they
estimated that the deposits will increase by $100,000 per year for only
9 years thereafter, then cease. Determine the equivalent (a) present
worth, and (b) annual series amounts, if public funds earn at a rate of
5% per year.

Example 2
Suppose that we have the following cash flow:

End of Year Cash Flows ($)

1 8,000
2 7,000
3 6,000
4 5,000

Calculate the present equivalent at i = 15% per year