SEEM2440: Engineering Economics

Exercise 3 Solution

1. Solve the following questions:

a) When 1) nominal annual interest rate r, 2) monthly compounding, and 3) semi-annual cash flows
are given, which rate should we find to calculate the present value of the cash flows and how can
we derive the rate?
b) When 1) nominal annual interest rate r, 2) semi-annual compounding, and 3) monthly cash flows
are given, which rate should we find to calculate the present value of the cash flows and how can
we derive the rate?
c) When 1) nominal monthly interest rate r, 2) continuously compounding, and 3) annual cash
flows are given, which rate should we find to calculate the present value of the cash flows and
how can we derive the rate?
Solution:
a) We should find the effective semi-annual interest rate is . Since the effective annual rate iy is
iy = (1 + r/12)12 − 1,
6
r

1/2
is = (1 + iy ) −1= 1+ −1
12
b) We should find the effective monthly interest rate im . Since the effective annual rate iy is iy =
(1 + r/2)2 − 1,
r 1/6
 
1/12
im = (1 + iy ) −1= 1+ −1
2
c) We should find the effective annual interest rate iy . Since the effective monthly rate im is im =
er − 1,
iy = (1 + im )12 − 1 = e12r − 1

Remark: One conclusion that can be drawn from the above questions is as follows: When
• r s the nominal interest rate per period,
• M is the compounding frequency per period, and
• k is the cash-flow frequency per period,
we should find the following effective interest rate i to discount cash flows:
i = (1 + r/M )M/k − 1
since the effective interest rate per period is (1 + i)k − 1 = (1 + r/M )M − 1.

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2. A person needs $18,000 immediately as a down payment on a new home. Suppose that she can borrow
this money from her company credit union. She will be required to repay the loan in equal payments
made semi-annually over the next 12 years. The annual interest rate being charged is 10% compounded
continuously. What is the amount of each payment?
Solution: Since r = 10% and M = 2, the effective semi-annual interest rate is
i = e10%/2 − 1 ≈ 5.127%.
The down payment $18,000 should be the same with the present value of the payments for the whole
period. Thus,
1 1 1 1 − (1 + i)−24
 
$18, 000 = A + 2
+ ··· + =A .
1 + i (1 + i) (1 + i)24 i
Then,
$18, 000i
A= ≈ $1, 320.6.
1 − (1 + i)−24

3. You plan to borrow a loan of $120,000 and find two options. Bank A offers a 5-year constant amor-
tization mortgage which requires monthly payments with annual interest rate of 5% compounded
continuously. Bank B offers a 3-year constant payment mortgage which requires monthly payments
with annual interest rate of 3% compounded monthly.
Assume that you choose Bank A’s loan.
a) What is the effective monthly interest rate?
b) What is the final balance at the end of the 7th month?
c) What are the principal payment and the interest payment at the end of the 8th month?
Assume that you choose Bank B’s loan.
d) (10pt) What is the amount of the payment at the end of the 8th month?
e) (10pt) What is the final balance at the end of the 8th month?
f) (10pt) What are the principal payment and the interest payment at the end of the 9th month?
Solution:
• Bank A’s loan: P = $120, 000, r = 5%, N = 60, conti. comp., CAM
a) What is the effective monthly interest rate?
i = er/12 − 1 = e5%/12 − 1 ≈ 0.4175%.
b) What is the final balance at the end of the 7th month?
60 − 7
B7 = P = $106, 000.
60
c) What are the principal payment and the interest payment at the end of the 8th month?
P8 = P/N = $120, 000/60 = $2, 000.
 
I8 = iB7 = e5%/12 − 1 ($106, 000) ≈ $442.6.

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• Bank B’s loan: P = $120, 000, r = 3%, N = 36, monthly comp., CPM
d) (10pt) What is the amount of the payment at the end of the 8th month?
Monthly interest rate i = r/12 = 3%/12 = 0.25%. Because it is a CPM, the payment is
constant over time. We have
A 1 − (1 + i)−36


1 1 1
 
P =A + 2
+ ··· + = .
1 + i (1 + i) (1 + i)36 i

Thus,
iP
A= ≈ $3, 489.75.
1 − (1 + i)−36
e) (10pt) What is the final balance at the end of the 8th month?

A (1 + i)8 − 1
 

8 7 8
B8 = P (1+i) −A (1 + i) + · · · + (1 + i) + 1 = P (1+i) − ≈ $94, 257.6.
i

Bank B’s loan: P = $120, 000, r = 3%, N = 36, monthly comp., CPM
f) (10pt) What are the principal payment and the interest payment at the end of the 9th month?

I9 = iB8 = 0.25% × $94, 257.6 ≈ $235.64.

P9 = A − I9 ≈ $3, 489.75 − $235.64 = $3, 254.11.