Slide Sets to accompany Blank & Tarquin, Engineering
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Developed By:
Dr. Don Smith, P.E.
Department of Industrial
Engineering
Texas A&M University
College Station, Texas
Executive Summary Version
Chapter 4
Nominal and Effective
Interest
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LEARNING OBJECTIVES
1. Nominal and effective
interest rates
2. Effective annual interest
rates
3. Effective interest rates
4. Compare PP and CP
5. Single amounts
with PP ≥ CP
6. Series with PP ≥ CP
7. Single and series
with PP < CP
8. Continuous
compounding
9. Varying interest
rates
Notation:
CP = Compounding Period PP = Payment Period
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Sct 4.1 Nominal and Effective
Interest Rate Statements
Review simple interest and compound interest
definitions (from Chapter 1)
Compound Interest –
Interest computed on interest
For a given interest period
The time standard for interest computations – One Year
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Nominal Rate of Interest
Nominal interest rate definition:
An interest rate that does not include any
consideration of compounding
For example, 8% per year is a nominal rate
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Effective Interest Rate
Definition:
The effective interest rate is the actual rate
that applies for a stated period of time.
The compounding of interest during the time
period of the corresponding nominal rate is
accounted for by the effective interest rate.
The effective rate is commonly expressed on
an annual basis denoted as “i
a
”
All interest formulas, factors, tabulated values, and spreadsheet relations must
have the effective interest rate to properly account for the time value of money.
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Three Time Based Units
Time Period – The period over which the interest is
expressed (always stated).
Ex: “1% per month”
Compounding Period (CP) – The shortest time unit
over which interest is charged or earned.
Ex: “8% per year, compounded monthly”
Compounding Frequency – The number of times m
that compounding occurs within time period t.
Ex: “1% per month, compounded monthly” has m = 1
Ex: “10% per year, compounded monthly” has m = 12
One Year is segmented into: 365 days, 52 weeks, 12 months
One quarter is: 3 months with 4 quarters/year
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The Effective Rate Per CP
% per time period t r
m compounding periods per t m
r
=
The Effective rate per compounding period (CP) is:
Ex: r = 9% per year, compounded monthly:
m = 12 …….(12 months in a year)
i per month = 0.09/12 = 0.0075 or 0.75%/month
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Two Common Forms of Quotation
Two types of interest quotation:
1. Quotation using a Nominal Interest Rate
2. Quoting using an Effective Interest Rate
Nominal and Effective interest rates are common in
business, finance, and engineering economy
Each type must be understood in order to solve
problems where interest is stated in various ways
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Definition of a Nominal Interest
Rate
+ Nominal interest rate definition:
An interest rate that does not include any consideration of
compounding
+ Means “in name only”, “not the true, effective rate”
…
+ 8% per year, compounded monthly
8% is NOT the true effective rate (per year)
8% represents the nominal rate
Effective rate will consider the monthly compounding
Slide Sets to accompany Blank & Tarquin, Engineering
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410
Examples of Nominal Interest
Rates
1.5% per month for 24 months
Same as: (1.5%)(24) = 36% per 24 months
1.5% per month for 12 months
Same as: (1.5%)(12 months) = 18%/year
1.5% per 6month period for 1 year
Same as: (1.5%)(2 sixmonth periods) = 3% per year
1% per week for 1 year
Same as: (1%)(52 weeks) = 52% per year
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Sct 4.2 Effective Annual Interest
Rate
r = nominal interest rate per
year
m = number of
compounding periods per
year
i = effective interest rate
per compounding period
(CP) = r/m
i
a
= effective interest rate
per year
1/
(1 ) 1
m
eff a
i i = + ÷
r/year = eff i / CP ) X (CP / year)
=(i)X(m)
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Sct 4.3 Effective Interest Rates
for Any Time Period
How to calculate true, effective, annual interest rates.
We assume the year is the standard of measure for time.
The year can be comprised of various numbers of compounding
periods (within the year).
Equation [4.8] in the text is the effective interest rate
relation
r
i = (1+ ) 1
m
m
Effective ÷
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Example: Calculating the Effective
Rate
+ Interest is 8% per year, compounded quarterly
+ What is the effective annual interest rate?
+ Use Equation [4.8] with r = 0.08, m = 4
Effective i = (1 + 0.08/4)
4
– 1
= (1.02)
4
– 1
= 0.0824 or 8.24%/year
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414
Sct 4.4 Equivalence Relations:
Lengths of Payment Period (PP)
and Compounding Period (CP)
To be considered:
Frequency of cash flows may or may not equal
the frequency of interest compounding
If the frequency of the cash flow equals the
frequency of the interest compounding – No
Problem!
If not, must make adjustments
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Situations
Situation Text Reference
+PP = CP Sections 4.5 and 4.6
+PP > CP Sections 4.5 and 4.6
+PP < CP Section 4.7
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Sct 4.5 Equivalence Relation:
Single Amounts with PP ≥ CP
There are only single amount cash flows, that is, P and F values
To determine P or F using P = F(P/F,i,n) or F = P(F/P,i,n), there are
two equivalent methods to determine i and n in the factors.
Method 1. For the effective interest rate, i, in the factor:
Determine i over the CP using i= r/m
For the total number of periods, n, in the factor:
Determine the number of CP between
occurrence of P and F values using
n = (m)(number of payment periods)
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Sct 4.5 Equivalence Relation:
Single Amounts with PP ≥ CP
There are only single amount cash flows, that is, P and F values
To determine P or F using P = F(P/F,i,n) or F = P(F/P,i,n), there are
two equivalent methods to determine i and n in the factors.
Method 2.
Find the effective interest rate for the time period of the nominal
rate using effective i formula, Eq. [4.8]
Set n to the number of periods in the nominal rate statement
r
Effective i = (1+ ) 1
m
m
÷
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Single Amounts: Numerical Example
Using Method 1
+ Find future worth in 5 years if $5000 now earns
interest at 6% per year, compounded monthly.
+ Effective i per month is i = 6%/12 = 0.5%
+ Total number of CP for year and m = 12 times per
year is n = (12)(5) = 60 periods
F = 5000(F/P,0.5%,60) = 5000(1.3489)
= $6744
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Sct 4.6 Equivalence Relations:
Series with PP ≥ CP
When cash flows involve a series (A, G, or g)
the PP is defined by the frequency of the cash
flows
IF PP ≥ CP…
Calculate the effective i per payment period
Apply the correct n for the total number of
payments periods.
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Series: Numerical Example
A = $500 every 6 months
F
7
= ?
PP > CP since PP = 6months and CP = quarter
Calculate effective i per PP of 6months
i
6months
means adjusting r to fit the PP
r = 20% per year, compounded quarterly
0 1 2 3 4 5 6 7 Years
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Series: Numerical Example
Adjusting the interest rate
r = 20% per year, compounded quarterly
i/qtr = 0.20/4 = 0.05 = 5% per quarter
2 quarters in the 6month payment period
Effective i = (1.05)
2
– 1 = 10.25% per 6month
Now, the interest matches the payment period
Finding F
year 7
= F
period 14
F = 500(F/A,10.25%,14) = 500(28.4891)
= $14,244.50
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Sct 4.7 Single Amounts and
Series with PP < CP
This situation is different from the last where PP
≥ CP
Here, PP is less than the compounding period,
CP
Raises questions of how interperiod
compounding is handled
Study Example 4.10
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Sct 4.8 Effective Interest Rate
for Continuous Compounding
Recall that effective i = (1 + r/m)
m
– 1
What happens if the compounding frequency, m,
approaches infinity?
This means an infinite number of compounding periods within a
payment period, and
The time between compounding approaches “0”
A limiting value of i will be approached for a given value
of r
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Derivation of Continuous Compounding
Effective Rate
Rewrite the effective i
relation as
(1 ) 1 1 1
r
m
r
m
r r
m m
(
 
(
+ ÷ = + ÷

(
\ .
¸ ¸
(1 ) 1
m
r
i
m
= + ÷
Now, examine the impact
of letting “m” approach
infinity. This requires
taking the limit of the
above expression as
m ∞
Remember the definition
of the number e
1
lim 1 2.71828
h
h
e
h
÷·
 
+ = =

\ .
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425
Derivation of Continuous Compounding
Effective Rate
So that:
lim 1 1 1.
r
m
r
r
m
r
i e
m
÷·
(
 
(
= + ÷ = ÷

(
\ .
¸ ¸
The effective i when interest is compounded
continuously is then:
Effective i = e
r
– 1
To find the equivalent nominal rate given i when
interest is compounded continuously, apply:
ln(1 ) r i = +
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426
Sct 4.9 Interest Rates That Vary
Over Time
In practice, interest rates do not stay the same
over time unless by contractual obligation.
There can exist “variation” of interest rates over
time – quite normal!
If required, how is this situation handled?
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Varying Rates: Finding the
Present Worth
To find the present worth:
+ Bring each cash flow amount back to the desired
point in time at the interest rate for each period
according to:
P = F
1
(P/F,i
1
,1) + F
2
(P/F,i
1
,1)(P/F,i
2
,1) + …
+ F
n
(P/F,i
1
,1)(P/F,i
2
,1)(P/F,i
3
,1)…(P/F,i
n
,1)
This process can get computationally involved!
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Varying Rates: Observations
We seldom evaluate problem models with
varying interest rates except in special
cases.
If required, it is best to build a
spreadsheet model
It can be a cumbersome task to perform
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Chapter Summary
Many applications use and apply nominal and
effective compounding
Given a nominal rate – must get the interest rate to
match the frequency of the payments
Apply the effective interest rate per payment period
When comparing interest rates over different
payment and compounding periods, must calculate
the effective i to correctly compare P, F or A values
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Chapter Summary  continued
All time value of money interest factors
require use of an effective (true) periodic
interest rate
The interest rate, i, and the payment or cash
flow periods must have the same time unit
One may encounter varying interest rates.
An exact answer requires a sequence of
interest rates for each period
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Economy, 6
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Chapter 4
End of Slide Set