Lecture slides to accompany

Basics of Engineering Economy

by
Leland Blank and Anthony Tarquin

Chapter 3
Nominal and Effective
Interest Rates

Slide to accompany Blank and Tarquin © 2008 McGraw-Hill

Basics of Engineering Economy, 2008
3-1 All rights reserved
 Chapter 3 – Nominal & Effective Interest

TOPICS
PURPOSE
 Recognize nominal and
effective rates
Perform calculations for  Effective interest rates
interest rates and  Payment period (PP) and
cash flows that occur on compounding period (CP)
a time basis  Single amounts with
other than yearly PP ≥ CP
 Series with PP ≥ CP
 Single and series with
PP < CP
 Spreadsheet use
Slide to accompany Blank and Tarquin © 2008 McGraw-Hill
Basics of Engineering Economy, 2008
3-2 All rights reserved
 Sec 3.1 – Nominal and Effective Rate
Statements
Nominal rates
• Interest rate per time
period without regard to
compounding frequency
• Some nominal statements:
– 8% per year compounded
monthly
– 2% per month compounded
weekly
– 8% per year compounded
quarterly
– 5% per quarter compounded
monthly
Effective rates
• Interest rate is compounded
more frequently than once
per year/period
• Some statements indicating
an effective rate:
– 15% per year
– effective 8.3% per year
compounded monthly
– 2% per month compounded
monthly
– effective 1% per week
compounded continuously

Table 3.1 !!!

Slide to accompany Blank and Tarquin © 2008 McGraw-Hill
Basics of Engineering Economy, 2008
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 Sec 3.1 – Nominal and Effective Rate
Statements
Nominal rates vs Effective rates

• Nominal rates must be converted to Effective rates as

the formulas/tables were derived using Effective rates!

• Therefore very important to correctly identify Nominal

rates vs Effective rates…

Slide to accompany Blank and Tarquin © 2008 McGraw-Hill

Basics of Engineering Economy, 2008
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 Sec 3.2 – Effective Interest Rate Formula

• i = effective rate per some stated period, e.g., quarterly,

annually
• r = nominal rate for same time period
(r = nominal rate per period x number of periods)
• m = frequency of compounding per same time period

Slide to accompany Blank and Tarquin © 2008 McGraw-Hill

Basics of Engineering Economy, 2008
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 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 © 2008 McGraw-Hill
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 Sec 3.2 – Effective Interest Rate
Example: Find i per year, if m = 4 for
quarterly compounding, and
r = 12% per year

r m
Effective i = (1+ )  1
m
Stated period for i is YEAR

i = (1 + 0.12/4)4 - 1 = 12.55%

Slide to accompany Blank and Tarquin © 2008 McGraw-Hill

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 Sec 3.2 – Nominal and Effective Rates
Nominal
r = rate/period × periods
Example: Rate is 1.5% per
month. Determine nominal
rate per quarter, year, and
over 2 years
Qtr: r = 1.5 × 3 mth = 4.5%
Year: r = 1.5 ×12 mth = 18%
= 4.5 × 4 qtr = 18%
2 yrs: r =1.5 × 24 mth = 36%
= 18 × 2 yrs = 36%
Slide to accompany Blank and Tarquin
Basics of Engineering Economy, 2008
Effective
r m
Effective i = (1+ )  1
m
Example: Credit card rate is 1.5% per
month compounded monthly. Determine
effective rate per quarter and per year
Period is quarter:
r = 1.5 × 3 mth = 4.5%
m=3
i = (1 + 0.045/3)3 – 1 = 4.57% per quarter
Period is year: r = 18% m = 12
i = (1 + 0.18/12)12 - 1) = 19.6% per year
NB: 19.6% > 4 x 4.57% !!!
© 2008 McGraw-Hill
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 Sec 3.2 – Effective Interest Rate
As m → ∞, continuous compounding is
approached
effective i = (℮r – 1)

Example: r = 14% per year compounded

continuously

i = (℮ 0.14 - 1) = 15.03% per year

Slide to accompany Blank and Tarquin © 2008 McGraw-Hill
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 Sec 3.2 – Nominal and Effective Rates
Using Excel functions to find rates

Slide to accompany Blank and Tarquin © 2008 McGraw-Hill

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 Sec 3.3 – Payment Periods (PP)
and Compounding Periods (CP)
• PP – how often cash flows occur
• CP – how often interest in compounded
• If PP = CP, no problem concerning effective i rate

Examples where effective i is involved:

Monthly deposit, quarterly compounding (PP < CP)
Semi-annual payment, monthly compounding (PP > CP)

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 Sec 3.3 – Payment Periods (PP)
and Compounding Periods (CP)
Initial things to observe about cash flows
1. Compare length of PP with CP
i) PP = CP ii) PP > CP iii) PP < CP
2. Determine types of cash flows present
• Only single amounts (P and F)
• Series (A, G, g)
3. Determine correct effective i and n (same time
unit on both)

Remember: An effective i rate must be

used in all factors
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 Sec 3.4 – Equivalence with Single Amounts
If only P and F cash flows are present, equivalence relations are
P = F(P/F, effective i per period, # of periods) [1]
F = P(F/P, effective i per period, # of periods) [2]
Example: Find equivalent F in 10 years if P is $1000 now. Assume
r = 12% per year compounded semi-annually.

- PP = year and CP = 6 months; period is 6 months

- Only single amount cash flows
- Use relation [2] above to find F Why 6% ???

F = 1000(F/P, 6% semi-annually, 20 periods)

= 1000(3.2071) = $3207

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 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. Determine F.
PP = CP = month
n = 36 months
effective i = 1% per month

Relation: F = A(F/A,1%,36)
Slide to accompany Blank and Tarquin © 2008 McGraw-Hill
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 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: $5000 per quarter for 6 years at 12% per year

compounded monthly
PP = quarter and CP = month → PP > CP
n = 24 quarters
r = 1% per month or 3% per quarter
m = 3 CP per quarter
effective i per quarter = (1 + 0.03/3)3 – 1 = 3.03%
Relation: F = A(F/A,3.03%,24)
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 Sec 3.5 – Equivalence with Series and PP ≥ CP

P = $3M

• First step: Find P for n = 10 annual payments

• Period is year
• CP = 6 months; PP = year; PP > CP
• Effective i per year = (1 + 0.08/2)2 – 1 = 8.16%
Relation: P = 3M + 200,000(P/A,8.16%,10) = $4,332,400
(continued →)
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 Sec 3.5 – Equivalence with Series and PP ≥ CP

P = $3M

• Second step: Find A for n = 20 semi-annual amounts

• Period is six months
• CP = 6 months; PP = 6 months; PP = CP
• Effective i per 6 months = 8%/2 = 4%
Relation: A = 4,332,400(A/P,4%,20) = $318,778
Slide to accompany Blank and Tarquin © 2008 McGraw-Hill
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 Sec 3.6 – Equivalence with Series and PP < CP

Example: deposits monthly (PP) with interest

compounded semi-annually (CP)

Result: PP < CP

Usually, interest is not paid on interperiod

deposits

For equivalence computations: Cash flows are

‘moved’ to match CP time period
Slide to accompany Blank and Tarquin © 2008 McGraw-Hill
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 Sec 3.6 – Equivalence with Series and PP < CP

APPROACH NORMALLY TAKEN

Move cash flows not at end of a compounding period:

 Deposits ( minus cash flows) - to end of period
 Withdrawals (plus cash flows) - to beginning of same
period (which is the end of last period)

Example (next slide): move monthly deposits to match

quarterly compounding. Now, PP = CP = quarter
 Find P, F or A using effective i per quarter

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Sec 3.6 – Equivalence with Series and PP < CP
Moving cash flows turns top cash flow diagram into bottom

Qtr 1 Qtr 2 Qtr 3 Qtr4

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 Sec 3.7 – Spreadsheet Usage
Spreadsheet function format and structure:
Fine effective rate: = EFFECT(nom r%, m)
Nominal r is over same time period as effective i
 Find nominal rate: = NOMINAL(eff i%, m)
Result of nominal is always per year

Example: Deposits are planned as follows: $1000

now, $3000 after 4 years, $1500 after 6 years.
Find F after 10 years. Interest is 12% per year
compounded semiannually

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 Sec 3.7 – Spreadsheet Usage

Slide to accompany Blank and Tarquin © 2008 McGraw-Hill

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