You are on page 1of 13

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

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

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%

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
=
(
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

 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)

 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?

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) # 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

= 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

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 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 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.

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

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)

= \$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
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 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
2 yrs
0
A ?
⎛ 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+ / ] 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
1st Qtr
2nd Qtr
1%
1%
1%
3.030 %

One-year Effective interest rate per quarter

Effective annual interest rate

1 2
i a (
=
1 +
0 01
.)
−=
1
12 68%
.
4
i a (.
=
1
+
0 03030
)
−=
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 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 4: Understanding Money & Its Management - 1

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 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

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