ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Chapter 5: Understanding Money & Its Management
1. If interest period is other than annual, how do we calculate economic equivalence? 2. If payments occur more frequently than annual, how do we calculate economic equivalence?
Nominal and Effective Interest Rates with Different Compounding Periods
Effective Rates 

Nominal Rate 
Compounding 
Compounding 
Compounding 
Compounding 
Compounding 

Annually 
Semiannually 
Quarterly 
Monthly 
Daily 

4% 
4.00% 
4.04% 
4.06% 
4.07% 
4.08% 

5 
5.00 
5.06 
5.09 
5.12 
5.13 

6 
6.00 
6.09 
6.14 
6.17 
6.18 

7 
7.00 
7.12 
7.19 
7.23 
7.25 

8 
8.00 
8.16 
8.24 
8.30 
8.33 

9 
9.00 
9.20 
9.31 
9.38 
9.42 

10 
10.00 
10.25 
10.38 
10.47 
10.52 

11 
11.00 
11.30 
11.46 
11.57 
11.62 

12 
12.00 
12.36 
12.55 
12.68 
12.74 
S.V. Atre
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Effective Annual Interest Rates (9% compounded quarterly)
First quarter 
Base amount 
$10,000 

+ Interest (2.25%) 
+ $225 

Second quarter 
= New base amount 
= $10,225 

+ Interest (2.25%) 
+$230.06 

Third quarter 
= New base amount 
= 
$10,455.06 
+ Interest (2.25%) 
+$235.24 

Fourth quarter 
= New base amount 
= $10,690.30 

+ Interest (2.25 %) 
+ $240.53 

= Value after one year 
= $10,930.83 
Effective Annual Interest Rate
i
a = (1+
r
/
M
)
M −1
r = nominal interest rate per year
i _{a} = effective annual interest rate
M = number of interest periods per year
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Equivalence Analysis using Effective Interest Rate
Identify the compounding period (e.g., annually, quarterly, monthly Identify the payment period (e.g., annual, quarter, month, week, etc), etc) Find the effective interest rate that covers the payment period.
When Payment Periods and Compounding Periods Coincide
Step 1: Identify the number of compounding periods (M) per year Step 2: Compute the effective interest rate per payment period (i) i = r/M Step 3: Determine the total number of payment periods (N) N = M (number of years) Step 4: Use the appropriate interest formula using i and N above
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Effective Interest Rate per Payment Period (i)
i
C
=[1+ / ] −1
r
CK
C 
= number of interest periods per payment period 
K 
= number of payment periods per year 
r/K = nominal interest rate per payment period
What happens when payment period is not annual?
Case 1: 8% compounded quarterly
Payment Period = Quarter Interest Period = Quarterly
1 ^{s}^{t} Q
2
^{n}^{d} Q
3
^{r}^{d} Q
4
^{t}^{h} Q
1 interest period
Given r = 8%,
K 
= 4 payments per year 
C 
= 1 interest periods per quarter 
M 
= 4 interest periods per year 
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Case 2: 8% compounded monthly
Payment Period = Quarter Interest Period = Monthly
1 ^{s}^{t} Q
2
^{n}^{d} Q
3
^{r}^{d} Q
4
^{t}^{h} Q
3 interest periods
Given r = 8%,
K 
= 4 payments per year 
C 
= 3 interest periods per quarter 
M 
= 12 interest periods per year 
Case 3: 8% compounded weekly
Payment Period = Quarter Interest Period = Weekly
1 ^{s}^{t} Q
2
^{n}^{d} Q
3
^{r}^{d} Q
4
^{t}^{h} Q
13 interest periods
_{G}_{i}_{v}_{e}_{n} _{r} _{=} _{8}_{%}_{,}
K 
= 4 payments per year 
C 
= 13 interest periods per quarter 
M 
= 52 interest periods per year 
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Payment Periods Differ from Compounding Periods
Step 1: Identify the following parameters
M = No. of compounding periods per year
K = No. of payment periods per year
C = No. of interest periods per payment period
Step 2: Compute the effective interest rate per payment period
•For discrete compounding
i = [1 +
r
/
CK
]
C − 1
Step 3: Find the total no. of payment periods N = K (no. of years) Step 4: Use i and N in the appropriate equivalence formula
r = 12%,
Discrete Case: Quarterly Deposits with Monthly Compounding
F _{3} = ?
Quarters
Step 1:
Step 2: i
M = 12 compounding periods/year
K = 4 payment periods/year C = 3 interest periods per quarter
i =
= 3.030 %
[1
+
0.12 /(3)(4)]
3
−
1
Step 3:
Step 4:
N = 4(3) = 12 F = $1,000 (F/A, 3.030%, 12)
= $14,216.24
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Problem 4
You will deposit $1000 every 3 months for 4 years into an account that pays interest of 8% per year, compounded monthly. The first deposit will be in 3 months. How much will be in the account in 4 years?
GIVEN: 

A 
= $1,000 
r 
= 
8%/yr 

C = 3 periods/qr 
K = 4 payments/yr 

M 
= 12 mo/yr 

FIND F: 
DIAGRAM:
0
1
2
3
_{F} _{?}
4 yrs
$1,000
Continuous Compounding
i = [1+
r
/
CK
]
C −1
where CK = number of compounding periods per year
C →∞
continuous compounding =>
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Case 4: 8% compounded continuously
Payment Period = Quarter Interest Period = Continuously
1 ^{s}^{t} Q
2
^{n}^{d} Q
3
^{r}^{d} Q
4
^{t}^{h} Q
∞ interest periods Given r = 8%,
K = 4 payments per year
i =
e r
/ K
− 1
= e
= 2.0201 % per quarter
0.02 − 1
Summary: Effective interest rate per quarter
Case 1 
Case 2 
Case 3 
Case 4 
8% compounded 
8% compounded 
8% compounded 
8% compounded 
quarterly 
monthly 
weekly 
continuously 
Payments occur 
Payments occur 
Payments occur 
Payments occur 
quarterly 
quarterly 
quarterly 
quarterly 
2.000% per 
2.013% per 
2.0186% per 
2.0201% per 
quarter 
quarter 
quarter 
quarter 
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Step 1:
Payment Periods Differ from Compounding Periods
Identify the following parameters
M = No. of compounding periods per year
K = No. of payment periods per year
C = No. of interest periods per payment period
Step 2: Compute the effective interest rate per payment period
•For discrete compounding
i 
= [1 + 
r 
/ 
CK 
] 
C − 1 

i = 
e 
r 
/ 
K − 
1 
•For continuous compounding
Step 3: Find the total no. of payment periods N = K (no. of years) Step 4: Use i and N in the appropriate equivalence formula
r = 12%,
Continuous Case: Quarterly Deposits with Continuous Compounding
Step 1:
K = 4 payment periods/year
C = ∞ interest periods per quarter
Step 2: i
Step 3:
Step 4:
i = e
0 12 4
.
/
− 1
= 3045% .
per quarter
N = 4(3) = 12 F = $1,000 (F/A, 3.045%, 12)
= $14,228.37
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Problem 5
Determine the total amount accumulated in an account paying interest at the rate of 10% per year, compounded continuously if deposits of $1,000 are made at the end of each of the next 5 years.
F ?
5 yrs
$1,000
GIVEN: 

A 
= $1,000 r 
= 
10%/yr 

C 
= ∞ 
K = 1 payment/yr 

N 
= 5 yrs 

FIND F: 
Problem 5
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Problem 6
A firm pays back a $10,000 loan with quarterly payments over the next 5 years. The $10,000 returns 4% APR compounded monthly. What is the quarterly payment amount ?
0
GIVEN:
5 yrs = 20 qtr
$A = ?
FIND A:
P 
= $10,000 r = 4%/yr 
C 
= 3 interest periods/quarter 
K 
= 4 payments/yr 
M 
= 12 compounding periods/yr 
0
Problem 6
GIVEN: 

P 
= $10,000 r = 4%/yr 

C 
= 3 interest periods/quarter 

K 
= 4 payment periods/yr 

M 
= 12 compounding periods/yr 

FIND A: 
5 yrs = 20 qtr
$A = ?
i =
= 1.0033 %
[1
+
0.04 /(3)(4)]
3
−
1
N = 4(5) = 20
A = $10,000 (A/P, 1.0033%, 20) = $554.30
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Complex Cash Flows
Complex Cash Flows – Separate complex cash flows into component cash flows in order to use the standard formulas.
Remember: You can only combine cash flows if they occur at the same point in time.
Problem 1
A construction firm is considering the purchase of an air compressor.
The compressor has the following expected end of year maintenance costs:
Year 1 
$800 
Year 2 
$800 
Year 3 
$900 
Year 4 
$1000 
Year 5 
$1100 
Year 6 
$1200 
Year 7 
$1300 
Year 8 
$1400 
What is the present equivalent maintenance cost if the interest rate is 12% per year compounded annually?
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Problem 1 – Alt Soln 1
GIVEN:
MAINT COST _{1}_{}_{8} PER YEAR TABLE
i = 12%/YR, CPD ANNUALLY
FIND P: P = P _{A} + P _{G} + P _{F} = A(PA,i,N) + G(PG,i,N) + F(PF,i,N)
DIAGRAM:
= $700(PA,12%,8) + $100(PG,12%,8) + $100(PF,12%,1)
= $700(4.9676) + $100(14.4715) + $100(0.8929) = $5,014
NOTE: CAN SEPARATE INTO 3 CASH FLOWS:
ANNUAL, LINEAR GRADIENT, AND FUTURE
N=8
N=1
N=8
$100
$700
DIAGRAM:
Problem 1 – Alt Soln 2
GIVEN:
MAINT COST _{1}_{}_{8} PER DIAGRAM
i = 12%/YR, CPD ANNUALLY
FIND P: P = P _{A} + P _{G} (P _{P}_{G} ) = A(PA,i,N) + G(PG,i,N1)(PF,i,1)
= $800(PA,12%,8) + $100(PG,12%,7)(PF,12%,1)
= $800(4.9676) + $100(11.6443)(0.8929) = $5,014
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Problem 2
A young couple has decided to make advance plans for financing their 3 year old daughter’s college education. Money can be deposited at 8% per year, compounded annually.
What annual deposit on each birthday, from the 4 ^{t}^{h} to the 17 ^{t}^{h} (inclusive), must be made to provide $7,000 on each birthday from the 18 ^{t}^{h} to the 21 ^{s}^{t} (inclusive)?
GIVEN:
WITHDRAWALS _{1}_{8}_{}_{2}_{1} = $7 000 i = r = 8%/YR, CPD YEARLY FIND A _{4}_{}_{1}_{7} :
P _{1}_{7} = A(PA,i,N) = A(FA,i,N)
= 7 000(PA,8%,4) = A(FA,8%,14)
= 7 000(3.3121) = A(24.2149)
A ?
STRATEGY: CAN BREAK INTO 2 CASH FLOWS, SO PICK A CONVENIENT POINT IN TIME AND SET DEPOSITS EQUAL TO WITHDRAWALS…
A = $957
Problem 3
Anita PlassTuwurk, who owns an engineering consulting firm, bought an old house to use as her business office. She found that the ceiling was poorly insulated and that the heat loss could be cut significantly if 6 inches of foam insulation were installed. She estimated that with the insulation she could cut the heating bill by $40 per month and the air conditioning cost by $25 per month. Assuming that the summer season is 3 months (June, July, August) of the year and the winter season is another 3 months (December, January, and February) of the year, how much can she spend on insulation if she expects to keep the property for 5 years? Assume that neither heating nor air conditioning would be required during the fall and spring seasons. She is making this decision in April about whether to install the insulation in May. If the insulation is installed, it will be paid for at the end of May. Anita’s interest rate is 9%, compounded monthly.
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
GIVEN:
Problem 3
SAVINGS = $40/MO(DEC,JAN, FEB); $25/MO (JUN, JUL, AUG)
r = 9%/YR, CPD MONTHLY
^{F}^{I}^{N}^{D} ^{P} (SAVINGS OVER 5 YEARS) ^{:}
1 ^{S}^{T} YR DIAGRAM:
5 YR DIAGRAM:
0
i =
r = 0.09 = 0.75% / MO
M
12
P _{A} = P _{α} + P _{β} (P _{P}_{β} ) = A _{α} (PA,i,N _{α} ) + A _{β} (PA,i,N _{β} )(PF,i,6)
= $25(PA,0.75%,3) + $40(PA,0.75%,3)(PF,0.75%,6)
= $25(2.9556) + $40(2.9556)(0.9562) = $186.94
GIVEN:
Problem 3
SAVINGS = $40/MO(DEC,JAN, FEB); $25/MO (JUN, JUL, AUG)
r = 9%/YR, CPD MONTHLY
^{F}^{I}^{N}^{D} ^{P} (SAVINGS OVER 5 YEARS) ^{:}
5 YR DIAGRAM:
0
+
0
$186.94
5 YRS
= 0
P ? 
P 
P A 
A 
A(P  A,i,N) 

C 
= 12 
K 
= 
1 
= 
P 0 + 
= 
+ 

⎡ 
(1 
i) 
N 
1 ⎤ 

A 
A 
+ 
− 

C
⎛
r
⎞
i
=
⎜
1
+
⎟
⎝
CK
⎠
12
⎛
0.09 ⎞
=
⎜
1
+
⎟
− 1 
= = 
+ $186.94 
⎢ ⎣ 
i(1 + 
i) N ⎥ ⎦ + $186.94(P  A,9.38%,4) 

− 1 
⎡ 
(1 
+ 0.0938) 4 
⎤ ⎥ ⎦ 

⎝ 
12(1) 
⎠ 
$186.94 
− 
1 

= 
+ 
$186.94 
⎢ 

= 9.38% 
⎣ 0.0938(1 
+ 
0.0938) 
4 

= 
$186.94 
+ 
$186.94[3.21288] 
= 
$787.56 
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Credit Card Debt
Annual fees Annual percentage rate Grace period Minimum payment Finance charge

Methods of Calculating Interest on Credit Card 

Method 
Description 
Interest You Owe 

Adjusted 
The bank subtracts the amount of your payment from the beginning balance and charges you interest on the remainder. This method costs you the least. 
Your beginning balance is $3,000. With the $1,000 payment, your new balance will be $2,000. You pay 1.5% on this new balance, which will be $30. 

Balance 

Average 
The bank charges you interest on the average of the amount you owe each day during the period. So the larger the payment you make, the lower the interest you pay. 
Your beginning balance is $3,000. With your $1,000 payment at the 15 ^{t}^{h} day, your balance will be reduced to $2,000. Therefore, your average balance will be (1.5%)($3,000+$2,000)/2=$37.50. 

Daily 

Balance 

Previous 
The bank does not subtract any payments you make from your previous balance. You pay interest on the total amount you owe at the beginning of the period. This method costs you the most. 
Regardless of your payment size, the bank will charge 1.5% on your beginning balance $3,000: (1.5%)($3,000)=$45. 

Balance 

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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007

Buying versus Lease Decision 

Option 1 
Option 2 

Debt Financing 
Lease Financing 

Price 
$14,695 
$14,695 

Down payment 
$2,000 
0 

APR (%) 
3.6% 

Monthly payment 
$372.55 
$236.45 

Length 
36 months 
36 months 

Fees 
$495 

Cash due at lease end 
$300 

Purchase option at lease end 
$8.673.10 

Cash due at signing 
$2,000 
$731.45 
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ENGR 390 Lecture 5: Understanding Money & Its Management  2
Winter 2007
Which Option is Better?
Debt Financing:
P _{d}_{e}_{b}_{t} = $2,000 + $372.55(P/A, 0.5%, 36)  $8,673.10(P/F, 0.5%, 36) = $6,998.47
Lease Financing:
P _{l}_{e}_{a}_{s}_{e} = $495 + $236.45 + $236.45(P/A, 0.5%, 35) + $300(P/F, 0.5%, 36) = $8,556.90
Summary
Financial institutions often quote interest rate based on an APR. In all financial analysis, we need to convert the APR into an appropriate effective interest rate based on a payment period. When payment period and interest period differ, calculate an effective interest rate that covers the payment period.
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