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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 Semi-annually 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

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

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

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 st Q 2

nd Q

3

rd Q

4

th Q 1 interest period

Given r = 8%,

 K = 4 payments per year C = 1 interest periods per quarter M = 4 interest periods per year C
i =
[ 1
+
r
/] CK
1
1
=+
[
1
0 08
.
/ (
1
)(
4
)]
1
= 2 000%
.
per quarter

ENGR 390 Lecture 5: Understanding Money & Its Management - 2

Winter 2007 Case 2: 8% compounded monthly

Payment Period = Quarter Interest Period = Monthly

1 st Q   2

nd Q

3

rd Q

4

th Q 3 interest periods

Given r = 8%,

 K = 4 payments per year C = 3 interest periods per quarter M = 12 interest periods per year C
i =
[ 1
+
r
/] CK
1
3
=+
[
1
0 08
.
/ (
3
)(
4
)]
1
= 2 013%
.
per quarter Case 3: 8% compounded weekly

Payment Period = Quarter Interest Period = Weekly

1 st Q     2

nd Q

3

rd Q

4

th Q 13 interest periods

Given r = 8%,

 K = 4 payments per year C = 13 interest periods per quarter M = 52 interest periods per year C
i =
[ 1
+
r
/] CK
1
1 3
=+
[
1
0 08
.
/ (
13
)(
4
)]
1
= 2 0186%
.
per quarter

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 Year 1
Year 2
Year 3
0
1
2
3
4
5
6
7
8
9
10
11
12
A = \$1,000

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

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 3
i =
[1
+
0.08 /(3)(4)]
1
= 2.0130 %
N
= 4(4) = 16
F
= \$1,000 (F/A, 2.013%, 16)
= \$18,658.12 Continuous Compounding

i = [1+

r

/

CK

]

C 1

where CK = number of compounding periods per year

C →∞

continuous compounding => C
i lim[( 1
=
+
r
/
CK
)
1]
r
/
K
= − 1
e

ENGR 390 Lecture 5: Understanding Money & Its Management - 2

Winter 2007 Case 4: 8% compounded continuously

Payment Period = Quarter Interest Period = Continuously

1 st Q 2

nd Q

3

rd Q

4

th 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

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 F 3 = ?
Year 1
Year 2
Year 3
0
1
2
3
4
5
6
7
8
9
10
11
12
Quarters
A = \$1,000

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

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. DIAGRAM:
0 1
2
3

F ?

5 yrs

\$1,000

 GIVEN: A = \$1,000 r = 10%/yr C = ∞ K = 1 payment/yr N = 5 yrs FIND F:  DIAGRAM:
0 1
2
3

Problem 5 GIVEN:
A
= \$1,000
r
=
10%/yr
C
= ∞
K = 1 payment/yr
N
= 5 yrs
FIND F:
0.10/1
i = e
− 1
F ?
= 10.517 % per year
5 yrs
N
= 5
F
\$1,000
= \$1,000 (F/A, 10.517%, 5)
= \$6,168.25

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 DIAGRAM:
\$10,000
1 2
3

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 DIAGRAM:
\$10,000
1 2
3

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 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?

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(P|A,i,N) + G(P|G,i,N) + F(P|F,i,N)

DIAGRAM:

= \$700(P|A,12%,8) + \$100(P|G,12%,8) + \$100(P|F,12%,1)

= \$700(4.9676) + \$100(14.4715) + \$100(0.8929) = \$5,014 P ?
1
2
3
4
N=8
0
\$700
\$100 \$100
\$200
\$300
\$700

NOTE: CAN SEPARATE INTO 3 CASH FLOWS: P A ?
1
2
3
4
0

N=8 P F ?
\$700
0

N=1 P G ?
1
2
3
4
0
\$100
\$200
\$300

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 PG ) = A(P|A,i,N) + G(P|G,i,N-1)(P|F,i,1)

= \$800(P|A,12%,8) + \$100(P|G,12%,7)(P|F,12%,1)

= \$800(4.9676) + \$100(11.6443)(0.8929) = \$5,014 P ?
P A ?
1
2
3
4
1
2
3
4
N=8
N=8
0
0
\$800
\$800
P G ?
\$100
\$200
P PG ?
0
1
2
3
N=7
\$600
0
1
\$100
\$200
P G ?
NOTE: P G MUST BE OFFSET ONE YEAR – SO
BRING THE OFFSET YEAR BACK TO TIME ZERO
\$600

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 th to the 17 th (inclusive), must be made to provide \$7,000 on each birthday from the 18 th to the 21 st (inclusive)? DIAGRAM:
\$7,000
4 17
18
21 yrs
0

GIVEN:

WITHDRAWALS 18-21 = \$7 000 i = r = 8%/YR, CPD YEARLY FIND A 4-17 :

P 17 = A(P|A,i,N) = A(F|A,i,N)

= 7 000(P|A,8%,4) = A(F|A,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 Plass-Tuwurk, 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.

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

FIND P (SAVINGS OVER 5 YEARS) :

1 ST YR DIAGRAM: \$40
\$25
0
1
2
3
4
5
6
7
8
9 10 11 12 MO
P A ?
α
β

5 YR DIAGRAM:

0 P A
1
2
3
4
5 YRS
P ?

i =

r = 0.09 = 0.75% / MO

M

12

P A = P α + P β (P Pβ ) = A α (P|A,i,N α ) + A β (P|A,i,N β )(P|F,i,6)

= \$25(P|A,0.75%,3) + \$40(P|A,0.75%,3)(P|F,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

FIND P (SAVINGS OVER 5 YEARS) :

5 YR DIAGRAM:

0 1
2
3
4 \$186.94
1
2
3
4
5 YRS
P 0 ?

+

0 \$186.94
1
2
3
4
5 YRS
P A ?

\$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

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 th 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

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 ENGR 390 Lecture 5: Understanding Money & Its Management - 2

Winter 2007 Which Option is Better?

Debt Financing:

P debt = \$2,000 + \$372.55(P/A, 0.5%, 36) - \$8,673.10(P/F, 0.5%, 36) = \$6,998.47 Lease Financing:

P lease = \$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.