You are on page 1of 13

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

Winter 2007

Chapter 5: Understanding Money & Its Management 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?

economic equivalence? 2. If payments occur more frequently than annual, how do we calculate economic equivalence?

Nominal Versus Effective Interest RatesNominal Interest Rate : Interest rate quoted based on an annual period Effective Interest Rate

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

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

Winter 2007

18% Compounded Monthly Interest period Nominal interest rate Annual percentage rate (APR)

18% Compounded Monthly

Interest period
Interest
period
Nominal interest rate
Nominal
interest rate
18% Compounded Monthly Interest period Nominal interest rate Annual percentage rate (APR)
Annual percentage rate (APR)
Annual
percentage
rate (APR)
18% compounded monthly Question: Suppose that you in vest $1 for 1 year at an

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

 

i

a

=

0.1956 or 19.56%

 
 

18%

 
   
) 12 = $1.1956   i a = 0.1956 or 19.56%     18%    
: 1.5%

: 1.5%

: 1.5%

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

Winter 2007

Single Cash Flow Formula Single payment compound amount factor (growth factor) N F FP =
Single Cash Flow Formula
Single payment
compound amount
factor (growth factor)
N
F
FP
=
(
1 +
i
F
=
PF (
/
)
PiN ,, )
Given:
i
=
18
/ 12
=
1 . 5 %
0
N
=
12
months
N
P
=
$ 1
Find:
P
F
= 1(1.1956 )
From Interest Table
F
= $1.1956

Nominal and Effective Interest Rates with Different Compounding Periods 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 4: Understanding Money & Its Management - 1

Winter 2007

Effective Annual Interest Rates (9% compounded quarterly) (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

EquivalenceEquivalence CalculationsCalculations withwith MoreMore FrequentFrequent CompoundingCompounding r = nominal,

EquivalenceEquivalence CalculationsCalculations withwith MoreMore FrequentFrequent CompoundingCompounding

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

(1)

10% / 4 quarters = 2.5% compounded quarterly

(2)

Which would I rather have: 12% compounded annually or 12% compounded monthly?

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

Winter 2007

Let’s Show It! EFFECTIVE INTEREST RATE i a = effective interest rate per year compounded

Let’s Show It!

EFFECTIVE INTEREST RATE

i a

= 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

i a = (1 + .01) 12 – 1 = 12.68% compounded annually

Another example… r = 12% per year compounded semi-annually i semi-annual = 1 2 %

Another example…

r = 12% per year compounded semi-annually

i semi-annual

= 12% / 2 = 6% per 6 months

i a

= (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?

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

Winter 2007

Let’s Illustrate the Answer… r = 12% per year compounded daily i d a i

Let’s Illustrate the Answer…

r = 12% per year compounded daily

i daily

= 12%/365

= .000329

i a = (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 Ratei a = (1 + r / M ) M − 1 r = nominal

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 4: Understanding Money & Its Management - 1

Winter 2007

Problem 1 The local bank branch pays interest on savings accounts at the rate of

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:

r = 6%/yr M = 12mo/yr

NONE NEEDED!

FIND i a :

 

1

 

r ⎞ ⎟

M

 

i

=

+

1

a

M

12

 

=

1

+

0.06

 

1

− =

6.17%

 

12

 

Equivalence Analysis using Effective Interest Rate 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.

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

Winter 2007

When Payment Periods and Compounding Periods Coincide

When Payment Periods and Compounding Periods Coincide

When Payment Periods and Compounding Periods Coincide Step 1: Identify the number of compounding periods (

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

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

Would have had

 

1 pack a day

   

$169,325

 
 

2 packs a day

   

$339,650

 
 

3 packs a day

   

$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

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

Winter 2007

Sample Calculation: One Pack per DayStep 1: Identify compounding period “5.5% interest compounded weekly” Step 2: Compute the effective intere

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)

= $169,325

Weekly deposit amount, A = $1.75 x 7 = $12.25 per week

F = $12.25 (F/A, 0.10577%, 2600)

Problem 2 What amount must be deposited in an account paying 6% per year, compounded
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:
F 5 = $2,000
r
=
6%/yr
M
= 12 mo/yr
DIAGRAM:
FIND P:
$2,000
N
=
(M)(# yrs )
= ⎜
⎛ 12mos ⎞ ⎟ (5yrs )
=
60mos
yr
0
1
2
r
⎛ 0.06 ⎞ ⎛
1yr
5 yrs
i =
= ⎜
= 0.5% / mo
M
yr
12mo
P?
P
=
$2000 (P | F,0.5%,60 )
=
$2000 (0.7414 )
= $1482 .80

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

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:

P = $5,000 r = 12%/yr M = 12 mo/yr DIAGRAM: FIND A: $5,000 1
P
= $5,000
r
=
12%/yr
M
= 12 mo/yr
DIAGRAM:
FIND A:
$5,000
1
2 yrs
0
A ?
⎛ 12 mos ⎞ ⎟ (2 N = ( M )(# yrs ) = ⎜
⎛ 12 mos ⎞ ⎟ (2
N
=
(
M
)(#
yrs
)
= ⎜
yrs
)
= 24
mos
yr
⎠ ⎟
r
= ⎛ ⎜ 0.12
1 yr
i =
⎟= ⎞ 1% / mo
⎟ ⎟
M
yr
12 mo
⎝ ⎜
A =
$5000 (
A
|
P
,1%, 24 )
=
$5000 (0.0471 )
= $235 .50
Effective Interest Rate per Payment Period ( i ) i C = [1 + /

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?

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

12% compounded monthly Payment Period = Quarter Compounding Period = Month 3rd Qtr 4th Qtr
12% compounded monthly
Payment Period = Quarter
Compounding Period = Month
3rd Qtr
4th Qtr
1st Qtr
2nd Qtr
1%
1%
1%
3.030 %

One-year Effective interest rate per quarter

3.030 % One-year • Effective interest rate per quarter • Effective annual interest rate 1 2

Effective annual interest rate

1 2 i a ( = 1 + 0 01 .) −= 1 12 68%
1 2 i a ( = 1 + 0 01 .) −= 1 12 68%
1 2
i a (
=
1 +
0 01
.)
−=
1
12 68%
.
4
i a (.
=
1
+
0 03030
)
−=
1
12 68%
.
1 2 i a ( = 1 + 0 01 .) −= 1 12 68% .

i =

(1

+

0 .01 )

3

1

=

3 .030 %

Winter 2007

Case 1: 8% compounded quarterly Payment Period = Quarter Interest Period = Quarterly 1 s

Case 1: 8% compounded quarterly

Payment Period = Quarter Interest Period = Quarterly

1 st Q

2 n d Q 3 r d Q 4 t h Q

2

nd Q

3

rd Q

4

th Q

Q 2 n d Q 3 r d Q 4 t h Q 1 interest period

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
C
i =
[ 1
+
r
/] CK
1
1
=+
[
1
0 08
.
/ (
1
)(
4
)]
1
= 2 000%
.
per quarter

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

Winter 2007

Case 2: 8% compounded monthly Payment Period = Quarter Interest Period = Monthly 1 s

Case 2: 8% compounded monthly

Payment Period = Quarter Interest Period = Monthly

1 st Q

2 n d Q 3 r d Q 4 t h Q
2 n d Q 3 r d Q 4 t h Q
2 n d Q 3 r d Q 4 t h Q

2

nd Q

3

rd Q

4

th Q

Q 2 n d Q 3 r d Q 4 t h Q 3 interest periods

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
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 s

Case 3: 8% compounded weekly

Payment Period = Quarter Interest Period = Weekly

1 st Q

2 n d Q 3 r d Q 4 t h Q
2 n d Q 3 r d Q 4 t h Q
2 n d Q 3 r d Q 4 t h Q
2 n d Q 3 r d Q 4 t h Q
2 n d Q 3 r d Q 4 t h Q

2

nd Q

3

rd Q

4

th Q

Q 2 n d Q 3 r d Q 4 t h Q 13 interest periods

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 =+ [
C
i =
[ 1
+
r
/] CK
1
1 3
=+
[
1
0 08
.
/ (
13
)(
4
)]
1
= 2 0186%
.
per quarter

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

Winter 2007

Payment Periods Differ from Compounding Periods 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

r = 12%,

Discrete Case: Quarterly Deposits with Monthly Compounding

Year 1 Year 2 Year 3 0 1 2 3 4 5 6 7 8
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