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Lecture No.

11
Chapter 4
Contemporary Engineering Economics
Copyright 2010

Contemporary Engineering Economics, 5th edition, 2010
Equivalence Calculations using Effective
Interest Rates
Step 1: Identify the payment period (e.g., annual,
quarter, month, week, etc)

Step 2: Identify the interest period (e.g., annually,
quarterly, monthly, etc)

Step 3: Find the effective interest rate that covers the
payment period.
Contemporary Engineering Economics, 5th edition, 2010
Case I: When Payment Period is Equal to
Compounding Period
Step 1: Identify the number of compounding periods (M) per
year

Step 2: Compute the effective interest rate per payment
period (i)

Step 3: Determine the total number of payment periods (N)
Contemporary Engineering Economics, 5th edition, 2010
Example 4.4:
Calculating Auto
Loan Payments
Given:
MSRP = $20,870
Discounts & Rebates =
$2,443
Net sale price = $18,427
Down payment = $3,427
Dealers interest rate =
6.25% APR
Length of financing = 72
months

Find: the monthly payment
(A)

Solution:
Contemporary Engineering Economics, 5th edition, 2010
Dollars Down
in the Drain
Suppose you drink a cup
of coffee ($3.00 a cup) on
the way to work every
morning for 30 years. If you
put the money in the bank
for the same period, how
much would you have,
assuming your accounts
earns a 5% interest
compounded daily.

NOTE: Assume you drink a
cup of coffee every day
including weekends.










Solution:
Payment period = daily
Compounding period = daily

Contemporary Engineering Economics, 5th edition, 2010
5%
0.0137% per day
365
30 365 10,950 days
$3( / ,0.0137%,10950)
$76,246
i
N
F F A
= =
= =
=
=
Case II: When Payment Periods Differ from
Compounding Periods
Step 1: Identify the following parameters.
M = No. of compounding periods
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

For continuous compounding

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.

Contemporary Engineering Economics, 5th edition, 2010
[1 / ] 1
C
i r CK = +
/
1
r K
i e =
Example 4.5 Compounding
Occurs More Frequently than
Payments are Made (Discrete
Case)
Given: A = $1,500 per quarter, r
= 6% per year, M = 12
compounding periods per year,
and N = 2 years

Find: F

Step 1:
M = 12 compounding
periods/year
K = 4 payment
periods/year
C = 3 interest periods
per quarter

Step 2:







Step 3: N = 4(2) = 8



Solution:





F = $1,500 (F/A, 1.5075%, 8)
= $14,216.24


Contemporary Engineering Economics, 5th edition, 2010
3
0.06
1 1
12
1.5075% per quarter
i
| |
= +
|
\ .
=
Example 4.6
Compounding is Less
Frequent than
Payments
Given: A = $500 per month, r =
10% per year, M = 4 quarterly
compounding periods per year, and
N = 10 years

Find: F

Step 1:

M = 4 compounding
periods/year
K = 12 payment
periods/year
C = 1/3 interest period
per quarter

Step 2:









Step 3: N = 4(2) = 8



Solution:






F = $500 (F/A, 0.826%, 120)
= $101,907.89

Contemporary Engineering Economics, 5th edition, 2010
1/3
0.10
1 1
4
0.826%
i
| |
= +
|
\ .
=
A Decision Flow Chart on How to Compute the
Effective Interest Rate per Payment Period
Contemporary Engineering Economics, 5th edition, 2010
Contemporary Engineering Economics, 5th edition, 2010
Key Points
Financial institutions often quote interest rate
based on an APR.
In all financial analysis, we need to convert the APR
into an appropriate effective interest rate based on
a payment period.
When payment period and interest period differ,
calculate an effective interest rate that covers the
payment period. Then use the appropriate interest
formulas to determine the equivalent values