Course # 8012101 Fundamentals of Engineering

Economy

Lect. # 5
Nominal and Effective Interest Rates
&
Equivalence

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Revision for different factors of CF

To save time, use the calculated factor table provided

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Flash Back from before break .The Five Types of Cash Flows

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 General Questions

 Suppose that you deposited $1,000 in a savings account at the

beginning of a year where the annual interest rate is 18 %.
 [1] What would be the future worth?
 [2] What would be the future worth if the interest is compounded
monthly?

[1] When compounding yearly and with an interest rate of 18%

per year

Apparently, the end-of-year amount = 1,000(1+18%) = $1,180

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 General Questions

[2] When compounding monthly

 For each month, we have an interest rate of 0.18/12 = 1.5%
 The future worth F = P(1+i)12 = 1,000(1+0.015)12
= $1,195.61
 Thus, the annual effective interest rate = 19.561%

$1,195.61

18%

1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5% 1.5%

$1,000

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 18%

=1.5%
18% per year compounded monthly
or
1.5% per month for 12 months
=
19.56 % compounded annually

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Necessary Definitions

$1,195.61

18%

1.5%1.5%
1.5%1.5%
1.5%1.5%
1.5%1.5%
1.5%1.5%
1.5%1.5%

$1,000

 Time period = 12 months

 Payment period = 12 months
 Compounding period = 1 month
 Compounding frequency = 12
 Interest rate per compounding period = 1.5%

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Compounding and Effective Interest Rates

Compounding with monthly and annual interest rates

Compounding with monthly and semi-annual interest rates

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Compounding and Effective Interest Rates

compounding with monthly, semiannual, and annual interest rates

compounding with quarterly and annual interest rates

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Interest is quoted on the basis of:
1. Quotation using a Nominal Interest Rate
2. Quoting an Effective Periodic Interest Rate
Nominal and Effective Interest rates are commonly quoted in
business, finance, and engineering economic decision-making.
Each type must be understood in order to solve various
problems where interest is stated in various ways.

Interest rates can be quoted in many ways:

Interest equals “6% per 6-months”
Interest is “12%” (12% per what?)
Interest is 1% per month
“Interest is “12.5% per year, compounded monthly”
Interest is 12% APR (Annual percentage rate)
You must “decipher” the various ways to state interest and to do
calculations.
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 Nominal Interest Rates
A Nominal Interest Rate, r, is an interest Rate that does not include
any consideration of the compounding of interest.
r = (interest rate per period) .(No. of Periods)
Say: 1.5% per month for 12 months Same as (1.5%)*(12 months) = 18%per year.
1.5% per 6 months Same as (1.5%)*(6 months) = 9% per 6 months or
semiannual period.
A nominal rate (as quoted) does not reference the frequency of
compounding period.

A true Effective Interest Rate must then applied…

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 Effective Interest Rates

Quote: “12 percent compounded monthly” is translated as: 12% is the

nominal rate. “compounded monthly” conveys the frequency of the
compounding throughout the year.
For this quote there are 12 compounding periods within a year.
r% per time period, compounded ‘m’ times a year. ‘m’ denotes the number
of times per year that interest is compounded.
18% per year, compounded monthly
r = 18 % per year (same as nominal interest rate)
m = 12 interest periods per year

What is the effective annual interest rate (EAIR)? It must be larger

than 18% per year!

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 Effective Interest Rates

Effective rate per CP = r% per time period t = r

m compounding periods per t m
Where:

Compounding Period (CP) is the time unit used to determine the effect
of interest. It is determined by the compounding term in the interest
rate statement. If not stated, assume one year.

Time Period (t) is the basic time unit of the interest rate. The time
unit is typically one year but can be other time periods, such as
months, quarters, semiannual periods, etc. If not stated, assume one
year.

6% per year compounded monthly is equivalent to 6%/12 = 0.50% per

month. r = 6% , m = 12.

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 Effective Interest Rates

Effective ia = (1 + r/m)m –1 (Effective per payment period) where:

r = nominal interest rate per payment period (PP)

m = number of compounding periods per payment period (CP per PP)

Payments every 6 months, with interest compounded every quarter

CP CP CP CP

PP PP

-1=(1+

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 Effective Interest Rates for any Time Period

In many loan transactions or personal financial decisions the

compounding period (CP) may not be the same as the payment period
(PP). When this occurs the effective interest rate is typically
expressed over the same time period as the payments.
Example:
Bank pays 4% per year compounded quarterly and deposits are made every month.
CP = 4 times per year
PP = 12 times per year
PP refers to the deposits and withdrawals by an individual not a lending institution.
CP refers to the compounding of interest by the lending institution.

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 Equivalence

Example: You borrow $10,000 at an interest rate of 14% per year

compounded monthly. How much do you owe after 5 years?
F = P (F/P, ia, 5)
1) ia =(1+r/m)m-1=(1+0.14/12)12-1= 14.934% per year compounded yearly
F = $10,000 (1.14934)5 = $20,056.098

Or 1% per month for 5(12) = 60 months

2) ia = r/m = 14%/12 = 1.167 % per month compounded monthly
F = P(1+i)n= $10,000 (1+1.167%)60 = $20,056.098

Therefore we can conclude that 1.167% per month compounded

monthly for 60 months is equivalent to 14% per year compounded
monthly for 5 years. Both statements imply effective interest
rates! 16
 Equivalence Procedures

EQUIVALENCE CALCULATIONS INVOLVING SERIES WITH PP ≥ CP

Type 1. Payment period equals compounding period, PP = CP.

Type 2. Payment period is longer than compounding period, PP > CP.
Type 3. Payment period is shorter than compounding period, PP < CP.

Type 1. When PP = CP or PP > CP, the following procedure always applies:

Step 1. Count the number of payments and use that number as n. For example, if
payments are made quarterly for 5 years, n is 20.

Step 2. Find the effective interest rate over the same time period as n in step 1

For example, if n is expressed in quarters, then the effective interest rate per
quarter must be used.

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18
r= 12% per year compounded monthly PP>CP

Payment Period = Quarter

Compounding Period = Month

1st Qtr 2nd Qtr 3rd Qtr 4th Qtr

1% 1% 1%
3.030 %
One-year
• Effective interest rate per quarter
3*1%

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Case 0: r= 8% per Year compounded quarterly PP= CP

Payment Period = Quarter

Interest Period (compound period) = Quarterly

1st Q

2nd Q 3rd Q 4th Q

1 interest period Given r = 8% per year
r = 2 % per quarter
m = 1 interest periods per quarter

= (1+ 2%/1)¹ - 1 = 2% per Payment period (quarter)

iq = m -1
(1+ r/m)

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Case 1: 8% per year compounded Monthly PP > CP

Payment Period = Quarter

Interest Period (compound period) = Monthly

1st Q

2nd Q 3rd Q 4th Q

3 interest periods Given r = 8% per year
r = 2% per quarter
m = 3 interest periods per quarter

iq = (1+ r/m)m -1 = (1+ 0.02/3)3 - 1 = 2.013%

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Case 2: r= 8% per year compounded weekly PP > CP
Payment Period = Quarter
Interest Period (compound period) = Weekly

1st Q

2nd Q 3rd Q 4th Q

13 interest periods
Given r = 8% per year,
r = 2 % per quarter
m = 13 interest periods per quarter

iq = (1+ r/m)m -1 = (1+ 0.02/13)13 -1 = 2.0186%

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 Case 3: r= 8% per year compounded daily PP > CP
Payment Period = Quarter
Interest Period (compound period) = Daily

1st Q

2nd Q 3rd Q 4th Q

Given r = 8% per year,

365 days/4=91.25 interest periods
r = 2% per quarter
m = 91.25 interest periods per quarter

i = [1+ r/m] m – 1
i = [1+ (0.02/ 91.25) ] 91.25 – 1
= 2.0199% / Quarter

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Summary

Effective interest rate per quarter

Case 0 Case 1 Case 2 Case 3

8% 8% 8% 8%
compounded compounded compounded compounded
quarterly monthly weekly daily
Payments Payments Payments Payments
occur occur occur occur
quarterly quarterly quarterly quarterly
2.000% per 2.013% per 2.0186% per 2.0199% per
quarter quarter quarter quarter

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 Equivalence Procedures
Single Payments (P,F) when PP ≥ CP
Method 1:
Determine the effective interest rate over the compounding period CP,
and set n equal to the number of compounding periods between P and F.
P = F (P/F, effective i% per CP, total number of periods n)
F = P (F/P, effective i% per CP, total number of periods n)
Example:
i = 6% per year compounded semiannually
F=?
0 1 2 3 4
$1,000
$2,000
Payments are on a yearly basis. Interest compounded twice a year.
Therefore, PP > CP.
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 Equivalence Procedures
F = $2,000(F/P, 3%, 8) + $1,000 (F/P, 3%, 4)
Please note that the interest rate is quoted over a 6-month period which
corresponds with the total number of 6-month periods.
F = $2,000(1.2668) + $1,000(1.1255)= $3,659
Method 2:
Determine the effective interest rate for the time period t of the nominal rate,
and set n equal to the total number of periods using this same time period.
Example:
i = 6% per year compounded semiannually
Effective i% per year = ( 1 + 0.06/2)2 – 1 = 6.09% per year
F = $2,000(F/P, 6.09%, 4) + $1,000 (F/P, 6.09%, 2)
F = $2,000(1.0609)4 + $1,000(1.0609)2
F = $3,659 ($3,659 from Method 1)
Method 1 is preferred over Method 2 since tables are easier to use. 26
 Equivalence Procedures
Series (A,G and g) when PP = CP
Determine the effective interest rate over the compounding period CP or
PP, and set n equal to the number of compounding periods or payment
periods between P and F.
P = A(P/A, effective i% per CP or PP, total number of periods n)
F = A(F/A, effective i% per CP or PP, total number of periods n)
P = G(P/G, effective i% per CP or PP, total number of periods n)
F = G(F/G, effective i% per CP or PP, total number of periods n)
P = g(P/g, effective i% per CP or PP, total number of periods n)
F = g(F/g, effective i% per CP or PP, total number of periods n)

Onley use Formulas

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 Equivalence Procedures
Series (A,G and g) when PP > CP
Find the effective i per payment period and determine n as the toal number of
payment periods.
Example:
$1,000 is deposited every 6-months for the next 2 years. The account pays
8% per year compounded quarterly. How much money will be in the account
when then last deposit is made?
F=?

0 1
2 years
X X X X

A = $1,000 per 6-months

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 Equivalence Procedures

When PP > CP and you are dealing with series factors, this is
the only approach, which will result in the correct amount! 29
 Example [1]
 Find the amount after 10 years for the given cash flow diagram if the interest rate
is 12% per year compounded semiannually
 ia = (1 + r/m)m – 1= (1+0.12/2)2 – 1 = 12.36% Per year
 F = 1,000(F/P,12.36%,10)+3,000(F/P,12.36,6) +1,500(F/P,12.36%,4) = $11,634

 A second way to solve this question is as follows:

F = 1,000(F/P,6%,20)+3,000(F/P,6%,12)+1,500(F/P,6%,8) = $11,634

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 Example [2]

 If your credit card calculates the interest based on 12.5% annual percentage rate,
what is your monthly interest rate and annual effective interest rate, respectively?
 Your current outstanding balance is $2,000 and skips payments for 2 months.
What would be the total balance 2 months from now?

Monthly Interest Rate:

12.5%
i= = 1.0417%
12
Annual Effective Interest Rate:
iey=(1+12%/12)12-1 =13.24% , ia = (1 + 0.010417)12 -1 = 13.24%
Total Outstanding Balance:
F = B2 = $2, 000( F / P,1.0417%, 2)
= $2, 041.88

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 Example [3]
 Suppose your savings account pays 9% interest compounded quarterly. If you
deposit $10,000 for one year, how much would you have?

(a) Interest rate per quarter:

9%
i= = 2.25%
4
(b) Annual effective interest rate:
ia = (1 + 0.0225) 4 − 1 = 9.31%
(c) Balance at the end of one year (after 4 quarters)
F = $10, 000( F / P, 2.25%, 4)
= $10, 000( F / P, 9.31%,1)
= $10, 931

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 Example [4]
1- WHEN INTEREST PERIODS COINCIDE WITH PAYMENT PERIODS, PP=CP

An engineer plans to borrow $3000 from his company credit union, to be repaid in
24 equal monthly installments. The credit union charges interest at the rate of 1%
per month on the unpaid balance. How much money must the engineer repay each
month?

This problem can be solved by direct application, since the interest charges and
the uniform payments are both determined on a monthly basis:
A = P (A/P, 1%, mn) = $3000 (A/P, 1%, 24)

We conclude that the engineer must repay $141.22 at the end of every month for
24 months. Alternatively, Appendix A gives (A/p, 1%, 24) = 0.04707, whence
A = $3000(0.04707) = $141.21 per month

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Example [5]

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 Example [6]

2- WHEN INTEREST PERIODS ARE SMALLER THAN PAYMENT PERIODS, PP > CP

If the interest periods are smaller than the payment periods, then the interest
may be compounded several times between payments. One way to handle
problems of this type is to determine the effective interest rate for the given
interest period, and then treat each payment separately.

An engineer deposits $1000 in a savings account at the end of each year. If the
bank pays interest at the rate of 6% per year, compounded quarterly, how much
money will have accumulated in the account after 5 years?

The effective interest rate is i = 6%/4 = 1.5% per quarter; the first deposit
accumulates for 16 quarters; etc.

F = $1000(1.2690) + $1000(1.1956) + $1000(1.1265)+ $1000(1.0614)+ $1000(1.0000)

= $5652.50
Or 35
 Example [6]
Another procedure, which is usually more convenient, is to calculate an
effective interest rate for the given payment period, and then to proceed as
though the interest periods and the payment periods coincided. This effective
interest rate can be determined as follow:
= Per year

Uniform-series compound amount factor (F/A , i , n)

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 Example [7]

 For the past 7 years, an engineer was paying $500 every 6 months for the
software maintenance. What is the equivalent amount after the last
payment. Assume an interest rate of 20% per year and that the interest is
compounded quarterly
 We have: a payment period of ½ year through which the nominal interest
rate is r = 10% and we have within this ½ year 2 compounding periods
(m=2)
 The effective interest rate per 6 months (½ year ) = (1+0.1/2)2 – 1 = 10.25%
 F =A(F/A,i, n) = 500(F/A,10.25%,14) = $14,244

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Example [8]

+ % Semiannually

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 Equivalence Procedures

3- WHEN INTEREST PERIODS ARE LARGER THAN PAYMENT PERIODS, PP < CP

Single Payments (P,F) and Series Amounts (A, G, g) when PP < CP

Bank Policy:
1) Interest is not paid between compounding periods. Many banks
operate in this fashion.
2) Interest is paid or charged between compounding periods.
For a no-interperiod-interest policy, deposits are all regarded as
deposited at the end of the compounding period, and withdrawals
are all regarded as withdrawn at the beginning.

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Example [9]

Loss Profitable

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 Example [9]

F=1000[-150(F/P,3%,4)-200(F/P,3%,3)+(-175+90) (F/P,3%,2)+
165(F/P,3%,1)-50]=$-357,592 41