ENGR 390 Lecture 4: Understanding Money & Its Management  1
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
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ENGR 390 Lecture 4: Understanding Money & Its Management  1
Winter 2007
18% Compounded Monthly
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% 

: 1.5%
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ENGR 390 Lecture 4: Understanding Money & Its Management  1
Winter 2007
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 
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ENGR 390 Lecture 4: Understanding Money & Its Management  1
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 
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?
S.V. Atre
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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 annually
= ( 1 + interest rate per period) ^{#} ^{o}^{f} ^{p}^{e}^{r}^{i}^{o}^{d}^{s}  1
Example:
r 
= 12% per year compounded monthly 

i 
= 
12% / 12 months = 1 % compounded monthly 
i _{a} = (1 + .01) ^{1}^{2} – 1 = 12.68% compounded annually
Another example…
r = 12% per year compounded semiannually
^{i} semiannual
^{=} ^{1}^{2}^{%} ^{/} ^{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?
S.V. Atre
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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}_{l}_{y}
= 12%/365
= .000329
i _{a} = (1 + .000329) ^{3}^{6}^{5} – 1 = .12747 = 12.747% per year compounded annually
What happens if we let the compounding period get infinitely small?
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 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:
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
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.
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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 
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
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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(FA,I,N)
= $169,325
Weekly deposit amount, A = $1.75 x 7 = $12.25 per week
F = $12.25 (F/A, 0.10577%, 2600)
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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:
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?
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ENGR 390 Lecture 4: Understanding Money & Its Management  1
Oneyear • Effective interest rate per quarter
• Effective annual interest rate
i =
(1
+
0 .01 )
3
−
1
=
3 .030 %
Winter 2007
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 4: Understanding Money & Its Management  1
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 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
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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