Equivalence Calculations Involving Multiple

Interest Formulas
solution
(b) To find the equivalent F8, we can sum the equivalent values of all payments as of the end of the
eighth year (time eight).

• However, since the equivalent P0 is already known to be $1,203.82, we can directly calculate
F8 = P0(F/P, 20%, 8) = $1,203.82(4.2998) = $5,176.19.
Nominal and Effective Interest Rates
• Very often the interest period, or time between successive compounding,
is less than one year (e.g., daily, weekly, monthly, or quarterly). It has
become customary to quote interest rates on an annual basis, followed by
the compounding period if different from one year in length.
• For example, if the interest rate is 6% per interest period and the interest
period is six months, it is customary to speak of this rate as “12%
compounded semiannually.” Here the annual rate of interest is known as
the nominal rate, 12% in this case.
• A nominal interest rate is represented by r. But the actual (or effective)
annual rate on the principal is not 12%, but something greater, because
compounding occurs twice during the year.
• The actual or exact rate of interest earned on the principal during one year
is known as the effective rate. It should be noted that effective interest
rates are always expressed on an annual basis, unless specifically stated
otherwise.
• The effective interest rate per year is customarily designated by i and the
nominal interest rate per year by r.
• In engineering economy studies in which compounding is annual, i = r. The
relationship between effective interest, i, and nominal interest, r, is
i = (1 + r/M)𝑀 − 1,
where M is the number of compounding periods per year. It is now clear
from why i > r when M > 1.
• The effective rate of interest is useful for describing the compounding
effect of interest earned on interest during one year
Interest Formulas for Continuous Compounding
and Discrete Cash Flows
• In most enterprises, cash is flowing in and out in an almost
continuous stream. Because cash, whenever it’s available, can usually
be used profitably, this situation creates opportunities for very
frequent compounding of the interest earned.
• Continuous compounding assumes that cash flows occur at discrete
intervals (e.g., once per year), but that compounding is continuous
throughout the interval.
CONTINUOUS COMPOUNDING

• Discount factors for continuous compounding are

different from those for discrete compounding.
• The discounting factors can be calculated directly from
the nominal interest rate, r, and number of years, n,
without having to find the effective interest rate per
period.
Interest Formulas for Continuous Compounding
and Discrete Cash Flows