Professional Documents
Culture Documents
Chapter 3 - Nominal & Effective Interest: Basics of Engineering Economy
Chapter 3 - Nominal & Effective Interest: Basics of Engineering Economy
Chapter 3
Nominal and Effective
Interest Rates
1
Sec 3.1 – Nominal and Effective Rate
Statements
Nominal rates Effective rates
Interest rate per time period Interest rate is compounded more
without regard to frequently than once per year
compounding frequency Some statements indicating an
Some nominal statements: effective rate:
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 effective 1% per week compounded
5% per quarter compounded continuously
monthly
2
Sec 3.2 – Effective Interest Rate
Time
Compounding Period for period m must
frequency effective i for r equal
Annual annual year 1
Semi-annual annual year 2
Quarterly annual year 4
Monthly annual year 12
Daily annual year 365
Monthly semi-annual 6 months 6
Weekly quarterly quarter 12
Slide to accompany Blank and Tarquin
Basics of Engineering Economy, 2008 3 - 21 Slide to accompany Blank and Tarquin
Basics of Engineering Economy, 2008
r m
Effective i = (1+ ) 1
m
Stated period for i is YEAR
i = (1 + 0.12/4)4 - 1 = 12.55%
3
Sec 3.2 – Nominal and Effective Rates
Nominal Effective
r m
r = rate/period × periods Effective i = (1+ ) 1
m
Example: Rate is 1.5% per month. Example: Credit card rate is 1.5% per month
Determine nominal rate per compounded monthly. Determine effective rate
quarter, year, and over 2 years per quarter and per year
Qtr: r = 1.5 × 3 mth = 4.5%
Period is quarter:
Year: r = 1.5 ×12 mth = 18% r = 1.5 × 3 mth = 4.5%
= 4.5 × 4 qtr = 18% m=3
i = (1 + 0.045/3)3 – 1 = 4.57% per quarter
2 yrs: r =1.5 × 24 mth = 36%
= 18 × 2 yrs = 36% Period is year: r = 18% m = 12
As m → ∞, continuous compounding is
approached
effective i = (℮r – 1)
4
Sec 3.2 – Nominal and Effective Rates
Using Excel functions to find rates
5
Sec 3.3 – Payment Periods (PP)
and Compounding Periods (CP)
Initial things to observe about cash flows
1. Compare length of PP with CP
PP = CP PP > CP PP < CP
1. Determine types of cash flows present
• Only single amounts (P and F)
• Series (A, G, g)
2. Determine correct effective i and n (same time unit
on both)
6
Sec 3.5 – Equivalence with Series and PP ≥ CP
Count number of payments. This is n
Determine effective i over same time period as n
Use these i and n values in factors
Example: $75 per month for 3 years at 12% per year
compounded monthly
PP = CP = month
n = 36 months
effective i = 1% per month
Relation: F = A(F/A,1%,36)
Relation: F = A(F/A,3.03%,24)
Slide to accompany Blank and Tarquin
Basics of Engineering Economy, 2008 3 - 30 Slide to accompany Blank and Tarquin
Basics of Engineering Economy, 2008
7
Sec 3.5 – Equivalence with Series and PP ≥ CP
P = $3M
P = $3M
8
Sec 3.6 – Equivalence with Series and PP < CP
Result: PP < CP
9
Sec 3.6 – Equivalence with Series and PP < CP
Moving cash flows turns top cash flow diagram into bottom
10
Sec 3.7 – Spreadsheet Usage
11