CE 22

Engineering Economy

Lecture 3-3 : Money Time Relationships and Equivalence

Lecture 3-3

Money Time Relationships and Equivalence

CE 22 – Engineering Economy

Marjorie C. Turiano
Assistant Professor
Institute of Civil Engineering
College of Engineering
University of the Philippines Diliman
 Attendance Quiz
You are purchasing your first car that currently costs
PhP 1 Million. You apply for bank financing and they offered four

Lecture 3-3 : Money Time Relationships and Equivalence

payment schemes at 8% interest compounded annually:
a) 20% Downpayment, 80% payable for 5 years
b) 20% Downpayment, 80% payable for 10 years
c) 30% Downpayment, 70% payable for 5 years
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d) 30% Downpayment, 70% payable for 10 years

Determine the annual uniform payment for each scheme. Which

scheme will you choose? Briefly explain.
A.Y. 2019-2020, First Semester 2
 Outline
• Nominal and Effective Interest Rates

Lecture 3-3 : Money Time Relationships and Equivalence

CE 22 – Engineering Economy

A.Y. 2019-2020, First Semester 3

 Nominal and Effective Interest Rates
𝑖 = effective interest rate per interest period
𝑁 = number of compounding periods

Lecture 3-3 : Money Time Relationships and Equivalence

Normally, but not always, the interest period is taken as 1 year.
There may be subperiods of quarters, months, weeks, and so
forth.
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Which do you prefer to invest to, one with 𝑖 = 10% per month, or
the other with 𝑖 = 10% per quarter?

A.Y. 2019-2020, First Semester 4

 Nominal and Effective Interest Rates
24% compounded monthly

Lecture 3-3 : Money Time Relationships and Equivalence

Nominal Interest
Interest Rate Period
CE 22 – Engineering Economy

Annual
Percentage
Rate (APR)

A.Y. 2019-2020, First Semester 5

 Nominal and Effective Interest Rates
Nominal interest rate, 𝒓
𝑟 = interest rate per period × number of periods

Lecture 3-3 : Money Time Relationships and Equivalence

A rate of 2% per month is equal to
2% * 12 months per year = 24% per year (nominal interest rate)
2% * 3 months per quarter = 6% per quarter
CE 22 – Engineering Economy

A.Y. 2019-2020, First Semester 6

 Nominal and Effective Interest Rates
Interest may be computed (compounded):
• Annually – once a year (at the end of the year)

Lecture 3-3 : Money Time Relationships and Equivalence

• Every 6 months – 2 times a year (semi-annual)
• Every quarter – 4 times a year (quarterly)
• Every month – 12 times a year (monthly)
• Every day – 365 times a year (daily)
• Continuous – infinite number of compounding periods in a year
CE 22 – Engineering Economy

A.Y. 2019-2020, First Semester 7

 Nominal and Effective Interest Rates

24% compounded monthly

Lecture 3-3 : Money Time Relationships and Equivalence

Interest rate per month
𝑖 = 24%/12 = 2%
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Number of interest periods per year

𝑁 = 12

A.Y. 2019-2020, First Semester 8

 Nominal and Effective Interest Rates
Example 3.18
Suppose that you invest $1,000 for 1 year at a nominal interest

Lecture 3-3 : Money Time Relationships and Equivalence

rate of 24% compounded monthly. How much will it be equivalent
to at the end of the year? Compare with 24% compounded
annually.
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24%
𝐹 = 1000 𝐹/𝑃, , 1 × 12 = 𝟏𝟐𝟔𝟖. 𝟐𝟒
12
𝐹 = 1000 𝐹/𝑃, 24%, 1 = 𝟏𝟐𝟒𝟎

A.Y. 2019-2020, First Semester 9

 Nominal and Effective Interest Rates
Effective Interest rate, 𝒊𝒆𝒇𝒇
• Actual interest earned of paid in a year or some other time period

Lecture 3-3 : Money Time Relationships and Equivalence

• Annual Percentage Yield (APY)
CE 22 – Engineering Economy

A.Y. 2019-2020, First Semester 10

 Nominal and Effective Interest Rates
• Nominal Interest Rate, 𝒓 • Effective Interest Rate, 𝒊𝒆𝒇𝒇
• Interest rate quoted based on • Actual interest earned or paid in

Lecture 3-3 : Money Time Relationships and Equivalence

an annual period that does not a year or some other time
include any consideration of period
compounding

• Annual Percentage Rate (APR) • Annual Percentage Yield (APY)

CE 22 – Engineering Economy

A.Y. 2019-2020, First Semester 11

 Nominal and Effective Interest Rates
Effective Interest rate, 𝒊𝒆𝒇𝒇

Lecture 3-3 : Money Time Relationships and Equivalence

𝒓 𝑴
𝒊𝒆𝒇𝒇 = 𝟏+ −𝟏
𝑴

𝑖𝑒𝑓𝑓 = effective annual interest rate

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𝑟 = nominal interest rate per year

𝑀 = number of interest periods per year

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 Nominal and Effective Interest Rates
Example 3.19
Suppose your savings account pays 9% interest compounded

Lecture 3-3 : Money Time Relationships and Equivalence

quarterly. Determine the interest rate per quarter.

𝑟 9%
𝑖= = = 𝟐. 𝟐𝟓%
𝑀 4
CE 22 – Engineering Economy

A.Y. 2019-2020, First Semester 13

 Nominal and Effective Interest Rates
Example 3.20
Suppose your savings account pays 9% interest compounded

Lecture 3-3 : Money Time Relationships and Equivalence

quarterly. Determine the annual effective interest rate.

𝑀 4
𝑟 0.09
𝑖𝑒𝑓𝑓 = 1+ −1= 1+ − 1 = 𝟗. 𝟑𝟏%
𝑀 4
CE 22 – Engineering Economy

A.Y. 2019-2020, First Semester 14

 Nominal and Effective Interest Rates
Example 3.21
Suppose your savings account pays 9% interest compounded

Lecture 3-3 : Money Time Relationships and Equivalence

quarterly. If PhP 10,000 is deposited now, what will it be worth at
the end of the year?

𝑟 𝑀
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𝐹 = 10,000 𝐹/𝑃, 2.25%, 4 = 𝑃 1 + = 𝟏𝟎, 𝟗𝟑𝟎. 𝟖𝟑

𝑀
1
𝐹 = 10,000 𝐹/𝑃, 9.31%, 1 = 𝑃 1 + 𝑖𝑒𝑓𝑓 = 𝟏𝟎, 𝟗𝟑𝟎. 𝟖𝟑
*Note effect of rounding off interest rates

A.Y. 2019-2020, First Semester 15

 Nominal and Effective Interest Rates

Lecture 3-3 : Money Time Relationships and Equivalence

CE 22 – Engineering Economy

A.Y. 2019-2020, First Semester 16

 Nominal and Effective Interest Rates
Whenever payment and compounding periods differ from each
other, one must be transformed so that both conform to the same

Lecture 3-3 : Money Time Relationships and Equivalence

unit of time

Payment period

Interest period
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Payment period

Interest period

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 Nominal and Effective Interest Rates
Effective Interest Rate per Payment Period

Lecture 3-3 : Money Time Relationships and Equivalence

𝒓 𝒌
𝒊𝒆𝒇𝒇 𝐩𝐞𝐫 𝒌 = 𝟏+ −𝟏
𝑴

𝑖 = effective interest rate per 𝑘 payment period

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𝑘 = number of compounding periods per payment period

𝑀 = total number of interest periods per year

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 Nominal and Effective Interest Rates
Effective Interest Rate per Payment Period (Illustration)

Lecture 3-3 : Money Time Relationships and Equivalence

Interest is calculated
9% compounded monthly
and payments occur
quarterly
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𝑟 𝑘
𝑖𝑒𝑓𝑓 per 𝑘 = 1+ −1
𝑀

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 Nominal and Effective Interest Rates
Effective Interest Rate per Payment Period
Case 1 : Payment Period is Equal to Compounding Period

Lecture 3-3 : Money Time Relationships and Equivalence

1. Identify the number of compounding periods per year (M)
2. Compute the effective interest rate per payment period
3. Determine the total number of payment periods
(𝑁 = 𝑀 x number of years)
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4. Use 𝑖 and 𝑁 in the appropriate equivalence formula

A.Y. 2019-2020, First Semester 20

 Nominal and Effective Interest Rates
Example 3.22
Suppose you buy coffee ($3.00 per cup) every morning for 30 years. If

Lecture 3-3 : Money Time Relationships and Equivalence

you keep the money in the bank for the same period instead, how
much would you have assuming your accounts earns 5% interest
compounded daily. Neglect effect of leap years.
𝑖 = 5%ൗ365 = 0.0137% per day
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days
𝑁 = 30 years × 365 = 10,950 days
year
𝐹 5% 1+𝑖 𝑁−1
𝐹 = $3 , , 10950 = 𝐴 = $𝟕𝟔, 𝟐𝟑𝟖. 𝟗𝟏
𝐴 365 𝑖

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 Nominal and Effective Interest Rates
Effective Interest Rate per Payment Period
Case 2 : Payment Period Differs from Compounding Period

Lecture 3-3 : Money Time Relationships and Equivalence

1. Identify the number of interest compounding periods per year (𝑀)
2. Identify the number of payment periods per year (𝐶)
3. Identify the number of compounding periods per payment period
(𝑘 = 𝑀/𝐶)
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4. Compute the effective interest rate per payment period

5. Determine the total number of payment periods
(𝑁 = 𝐶 × number of years)
6. Use 𝑖 and 𝑁 in the appropriate equivalence formula

A.Y. 2019-2020, First Semester 22

 Nominal and Effective Interest Rates
Example 3.23
If you deposit $1,500 quarterly in a savings account, how much can

Lecture 3-3 : Money Time Relationships and Equivalence

you withdraw after 2 years in an interest rate of 6% per year
compounded monthly?

𝑀 = 12 compounding periods per year 𝑁 = number of years × 𝐾 = 2 × 4 = 8

𝐶 = 4 payment periods per year
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𝑘=
12 compounding periods
×
year
=3 𝐹 = 1500(𝐹 Τ𝐴 , 1.5075%, 8)
year 4 payments 1 + 0.015075 8 − 1
= $1,500
0.015075
0.06 3 = $𝟏𝟐, 𝟔𝟓𝟐. 𝟔𝟏
𝑖𝑒𝑓𝑓 per 𝑘 = 1 + −1=
12
1.5075% per quarter
A.Y. 2019-2020, First Semester 23
 Nominal and Effective Interest Rates
Example 3.24
If you deposit $500 per month at an interest rate of 10% per year

Lecture 3-3 : Money Time Relationships and Equivalence

compounding quarterly for 10 years, what will be your balance by end
of year 10?

𝑀 = 4 compounding periods per year 𝑁 = number of years × 𝐾 = 10 × 12

𝐶 = 12 payment periods per year = 120
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4 compounding periods year 𝐹 = 500(𝐹 Τ𝐴 , 0.8265%, 120)

𝑘= × = 1/3
year 12 payments 1 + 0.008265 120 − 1
= $500
0.008265
0.10 1/3 = $𝟏𝟎𝟏, 𝟗𝟒𝟏. 𝟕𝟒
𝑖𝑒𝑓𝑓 per 𝑘 = 1 + −1 =
4
0.8265% per month
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 References
• Sullivan, William G. Engineering Economy. Pearson
Education, 16th ed.

Lecture 3-3 : Money Time Relationships and Equivalence

CE 22 – Engineering Economy

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