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Engineering Economics 390. Courtesy of Atre, Sundar V Associate Professor, Oregon State University.

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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 Versus Effective Interest Rates
**

Nominal Interest Rate: Interest rate quoted based on an annual period Effective Interest Rate: Actual interest earned or paid in a year or some other time period

S.V. Atre

1

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

18% Compounded Monthly

Nominal interest rate

Interest period Annual percentage rate (APR)

**18% compounded monthly
**

Question: Suppose that you invest $1 for 1 year at an 18% compounded monthly. How much interest would you earn? Solution:

F = $ 1(1 + i )12 = $ 1(1 + 0 .015 )12

**= $1.1956 ia = 0.1956 or 19.56%
**

18%

: 1.5%

S.V. Atre

2

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

**Single Cash Flow Formula
**

Single payment compound amount factor (growth factor) Given: i = 18 / 12 = 1 . 5 % N = 12 months P = $1 Find:

F = P(1 + i) N F = P( F / P, i, N)

0

F

N P From Interest Table

F = 1(1.1956 ) F = $1.1956

**Nominal and Effective Interest Rates with Different Compounding Periods
**

Effective Rates

Nominal Rate Compounding Annually Compounding Semi-annually Compounding Quarterly Compounding Monthly Compounding Daily

4% 5 6 7 8 9 10 11 12

4.00% 5.00 6.00 7.00 8.00 9.00 10.00 11.00 12.00

4.04% 5.06 6.09 7.12 8.16 9.20 10.25 11.30 12.36

4.06% 5.09 6.14 7.19 8.24 9.31 10.38 11.46 12.55

4.07% 5.12 6.17 7.23 8.30 9.38 10.47 11.57 12.68

4.08% 5.13 6.18 7.25 8.33 9.42 10.52 11.62 12.74

S.V. Atre

3

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

**Effective Annual Interest Rates (9% compounded quarterly)
**

First quarter Second quarter Third quarter Fourth quarter

Base amount + Interest (2.25%) $10,000 + $225

= New base amount + Interest (2.25%)

= $10,225 +$230.06

= New base amount + Interest (2.25%)

= $10,455.06 +$235.24

= New base amount + Interest (2.25 %) = Value after one year

= $10,690.30 + $240.53 = $10,930.83

**Equivalence Calculations with More Frequent Compounding
**

r = nominal, annual interest rate and compounding period Examples: 12% per year compounded monthly (1) 10% per year compounded quarterly (2) i = interest rate per compounding period = annual interest rate

________________________________________________________________________

( # of compounding periods per year) Examples: 12% / 12 months = 1% compounded monthly 10% / 4 quarters = 2.5% compounded quarterly Which would I rather have: 12% compounded annually or 12% compounded monthly? (1) (2)

S.V. Atre

4

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

Let’s Show It!

EFFECTIVE INTEREST RATE ia = effective interest rate per year compounded annually = ( 1 + interest rate per period) # of periods - 1 Example: r = 12% per year compounded monthly i = 12% / 12 months = 1 % compounded monthly ia = (1 + .01)12 – 1 = 12.68% compounded annually

Another example…

r = 12% per year compounded semi-annually isemi-annual = 12% / 2 = 6% per 6 months

ia = (1 + .06)2 – 1 = .1236 = 12.36% per year compounded annually As the compounding period gets smaller, does the effective interest rate increase or decrease?

S.V. Atre

5

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

**Let’s Illustrate the Answer…
**

r = 12% per year compounded daily idaily = 12%/365 = .000329

**ia = (1 + .000329)365 – 1 = .12747 = 12.747% per year compounded annually
**

What happens if we let the compounding period get infinitely small?

Effective Annual Interest Rate

ia = (1 + r / M ) − 1

M

r = nominal interest rate per year ia = effective annual interest rate M = number of interest periods per year

S.V. Atre

6

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

Problem 1

The local bank branch pays interest on savings accounts at the rate of 6% per year, compounded monthly. What is the effective annual rate of interest paid on accounts?

GIVEN: DIAGRAM: NONE NEEDED! FIND ia: r = 6%/yr M = 12mo/yr r⎞ ⎛ ia = ⎜ 1 + ⎟ − 1 ⎝ M⎠ ⎛ 0.06 ⎞ = ⎜1 + ⎟ 12 ⎠ ⎝

12 M

− 1 = 6.17%

**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.

S.V. Atre

7

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

**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

Dollars Up in Smoke

What three levels of smokers who bought cigarettes every day for 50 years at $1.75 a pack would have if they had instead banked that money each week:

Level of smoker

1 pack a day 2 packs a day 3 packs a day

**Would have had
**

$169,325 $339,650 $507,976

Note: Assumes constant price per pack, the money banked weekly and an annual interest rate of 5.5% compounded weekly

Source: USA Today, Feb. 20, 1997

S.V. Atre

8

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

**Sample Calculation: One Pack per Day
**

Step 1: Identify compounding period

“5.5% interest compounded weekly”

**Step 2: Compute the effective interest rate per payment period.
**

Payment period = weekly i = 5.5%/52 = 0.10577% per week

**Step 3: Find the total number of deposit periods
**

N = (52 weeks/yr.)(50 years) = 2600 weeks

**Step 4: Use the appropriate formula F = A(F|A,I,N)
**

Weekly deposit amount, A = $1.75 x 7 = $12.25 per week F = $12.25 (F/A, 0.10577%, 2600) = $169,325

Problem 2

What amount must be deposited in an account paying 6% per year, compounded monthly in order to have $2,000 in the account at the end of 5 years?

GIVEN: F5 = $2,000 r = 6%/yr M = 12 mo/yr FIND P: $2,000 0 P? 1 2 5 yrs

⎛ 12 mos ⎞ N = (M )(# yrs ) = ⎜ ⎟( 5 yrs ) = 60 mos ⎝ yr ⎠ r ⎛ 0 .06 ⎞⎛ 1yr ⎞ =⎜ ⎟⎜ ⎟ = 0 .5 % / mo M ⎝ yr ⎠⎝ 12 mo ⎠ P = $ 2000 (P | F,0 .5 %, 60 ) = $ 2000 ( 0 . 7414 ) i= = $ 1482 . 80

DIAGRAM:

S.V. Atre

9

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

Problem 3

$5,000 is to be repaid in equal monthly payments over the next 2 years. The first payment is due in 1 month. Determine the payment amount at a nominal interest rate of 12% per year, compounded monthly.

GIVEN:

DIAGRAM: $5,000

**⎛ 12 mos ⎞ P = $5,000 N = ( M )(# yrs ) = ⎜ ⎜ yr ⎟ ( 2 yrs ) = 24 mos ⎟ r = 12%/yr ⎝ ⎠ M = 12 mo/yr ⎛ 0 . 12 ⎞ ⎛ 1 yr ⎞ r ⎟⎜ i= =⎜ ⎟ = 1 % / mo FIND A: M ⎜ yr ⎟ ⎝ 12 mo ⎠ ⎝ ⎠
**

1 2 yrs

A = $ 5000 ( A | P ,1 %, 24 ) = $ 5000 ( 0 .0471 ) = $ 235 .50

0 A?

Effective Interest Rate per Payment Period (i)

i = [1 + r / CK ]C − 1

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?

S.V. Atre

10

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

12% compounded monthly Payment Period = Quarter Compounding Period = Month

1st Qtr

1% 1% 1% 3.030 %

2nd Qtr

3rd Qtr

4th Qtr

**One-year • Effective interest rate per quarter i = (1 + 0 . 01 ) 3 − 1 = 3 . 030 % • Effective annual interest rate 12
**

i a = ( 1 + 0 .0 1 ) − 1 = 1 2 .6 8 %

i a = ( 1 + 0 .0 3 0 3 0 ) 4 − 1 = 1 2 .6 8 %

**Case 1: 8% compounded quarterly
**

Payment Period = Quarter Interest Period = Quarterly

1st Q

2nd Q

1 interest period

3rd Q

4th Q

Given r = 8%, K = 4 payments per year C = 1 interest periods per quarter M = 4 interest periods per year

i = [1 + r / C K ] C − 1 = [1 + 0 . 0 8 / (1 ) ( 4 ) ] 1 − 1 = 2 . 0 0 0 % p e r q u a r te r

S.V. Atre

11

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

Winter 2007

**Case 2: 8% compounded monthly
**

Payment Period = Quarter Interest Period = Monthly

1st Q

2nd Q

3 interest periods

3rd Q

4th Q

Given r = 8%, K = 4 payments per year C = 3 interest periods per quarter M = 12 interest periods per year

i = [1 + r / C K ] C − 1 = [1 + 0 . 0 8 / ( 3 ) ( 4 ) ] 3 − 1 = 2 . 0 1 3 % p e r q u a r te r

**Case 3: 8% compounded weekly
**

Payment Period = Quarter Interest Period = Weekly

1st Q

2nd Q

13 interest periods

3rd Q

4th Q

Given r = 8%, K = 4 payments per year C = 13 interest periods per quarter M = 52 interest periods per year

i = [1 + r / C K ] C − 1 = [1 + 0 . 0 8 / (1 3 )( 4 )]1 3 − 1 = 2 . 0 1 8 6 % p e r q u a rte r

S.V. Atre

12

ENGR 390 Lecture 4: Understanding Money & Its Management - 1

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

**Discrete Case: Quarterly Deposits with Monthly Compounding
**

Year 1

r = 12%, 0 1 2 3 4 5

Year 2

6 7 8

Year 3

9 10 11

12

F3 = ?

Quarters

A = $1,000

Step 1: M = 12 compounding periods/year

**K = 4 payment periods/year C = 3 interest periods per quarter
**

Step 2: i

i = [1 + 0 .12 /( 3)( 4 )] 3 − 1 = 3 .030 %

N = 4(3) = 12 F = $1,000 (F/A, 3.030%, 12)

Step 3: Step 4:

= $14,216.24

S.V. Atre

13

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