Engineering Economy

CHAPTER 4
NOMINAL AND EFFECTIVE
INTEREST RATE
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Flash Back
The Five Types of Cash Flows
(a)

Single cash flow

(b)

Equal (uniform) payment

series

(c)

Linear gradient series

(a)

Geometric gradient series

(b)

Irregular payment series

When interest rates vary with time different

procedures are necessary

Interest rates often change with time

(e.g., a variable rate mortgage).

We often must resort to moving cash flows

one period at a time, reflecting the interest
rate for that single period.

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Interest Rates that Vary with Time

The present equivalent of a cash flow (P/F, ik%,

k) occurring at the end of period N can be
computed with the equation below, where ik is
the interest rate for the kth period.

If , F4 = $2,500 and i1=8%, i2=10%, and i3=11%

Then,

P = $2,500(P/F, 8%,1)(P/F,10%,1)(P/F,11%,1)
= $2,500(0.9259)(0.9091)(0.9009) = $1,896
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Nominal and Effective Interest Rates

Sometimes,
time
between
successive
compounding, or the interest period, is less than
one year (e.g., daily, monthly, quarterly).

The annual rate is known as a nominal rate.

e.g. A nominal rate of 12%, compounded monthly

12% 12 months = 1% per month

The more frequent the compounding the greater

the effective interest.

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Compounding Frequency

Compounding can be performed at any interval

(common: quarterly, monthly, daily)

When this occurs, there is a difference between

nominal and effective annual interest rates
r = Nominal rate of interest
i = Effective interest rate per period

When the compounding frequency is annually: r

=i

When compounding is performed more than

once per year, the effective rate (true annual
rate) exceeds the nominal annual rate: i > r

Effective Annual Interest Rate (Yield)

This is determined by:

i 1

r = nominal interest rate per year

i = effective annual interest rate
M = number of interest periods per
year

$1000 Compounded at a Semiannual

Frequency (r= 12%, M=2)

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$1000 Compounded at a Monthly Frequency

(r= 12%, M=12)

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Finding effective interest rates.

For an 18% nominal rate, compounded

quarterly, the effective interest is.

For a 7% nominal rate, compounded monthly, the

effective interest is.

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Compounding Frequency
Example: If a student borrows $1,000 from a
finance company which charges
interest at a compound rate of 2% per
month:

What is the nominal interest rate:

r = (2%/month) x (12 months) = 24% annually

What is the effective annual interest rate:

i = (1 + r/M)M 1
i = (1 + 0.24/12)12 1 = 0.268 (26.8%)

Nominal and Effective

Annual Rates of Interest

Effective interest rate

rate compounded once a year which is equivalent to

the nominal interest rate compounded M times a
year

always greater than or equal to the nominal interest

rate

The greater the frequency of compounding

the greater the difference between effective
and nominal rates.

But it has a limit Continuous Compounding.

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

Comparison of Nominal Interest Rate and

Effective Interest Rate
Frequency
Annual

Nominal
Rate
12%

Semiannual
Quarterly

2
4

12%
12%

12.36%
12.55%

Monthly

12

12%

12.68%

Weekly

52

12%

12.73%

Daily

365

12%

12.75%

12%

12.75%

Continuously

Periods/year

Effective
Rate
12.00%

Effective Annual Interest Rates

(9% compounded quarterly)
First quarter

Base amount
+ Interest (2.25%)

$10,000
+ $225

Second quarter

= New base amount

+ Interest (2.25%)

= $10,225
+$230.06

Third quarter

= New base amount

+ Interest (2.25%)

= $10,455.06
+$235.24

Fourth quarter

= New base amount

+ Interest (2.25 %)
= Value after one year

= $10,690.30
+ $240.53
= $10,930.83

18% Compounded Monthly

What It Really Means?

Interest rate per month (i) = 18%/12 = 1.5%

Number of interest periods per year (M) = 12

In words,

Bank will charge 1.5% interest each month on

your unpaid balance, if you borrowed money

You will earn 1.5% interest each month on your

remaining balance, if you deposited money

18% Compounded Monthly

Nominal
interest rate

Interest
period
Annual
percentage
rate (APR)

18% compounded monthly

Question
Suppose that you invest $1 for 1 year at 18%
compounded monthly. How much interest
would you earn at the end of 1 year?
Solution:

F $1(1 i)12 $1(1 0.015)12

= $1.1956
i 0.1956 or 19.56%
18%

= 1.5%

18%

: 1.5%
18% compounded monthly
or
1.5% per month for 12 months

=
19.56 % compounded annually
Actual amount
earned

Practice Problem

If your credit card calculates the interest

based on 12.5% Annual Percentage Rate
(APR), what is your monthly interest rate and
annual effective interest rate, respectively?

Your current outstanding balance is $2,000

and skips payments for 2 months. What
would be the total balance 2 months from
now?

Solution
Monthly Interest Rate:
12.5%
i
1.0417%
12
Annual Effective Interest Rate:
12
12-1=13.24%
iai=(1+0.010417)

(1

0.010417)
13.24%
a

Total Outstanding Balance:

F B2 $2,000( F / P,1.0417%, 2)
$2,041.88

Practice Problem

Suppose your savings account pays 9%

interest compounded quarterly. If you deposit
$10,000 for one year, how much would you
have?

Solution
(a) Interest rate per quarter:
9%
i
2.25%
4
(b) Annual effective interest rate:
ia (1 0.0225) 4 1 9.31%
(c) Balance at the end of one year (after 4 quarters)
F $10, 000( F / P, 2.25%, 4)
Or,
$10, 000( F / P, 9.31%,1)
$10, 931

Tutorial 1 (Effective Interest Rate)

Suppose that a $100 lump-sum amount is

invested for 10 years at a normal interest rate
of 6% compounded quarterly. How much is it
worth at the end of the tenth year (Use EIR
method)?

Answer:
F= $181.40

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Compounding Frequency

It is also important to be able to calculate the

effective interest rate (i) for the actual interest
periods to be used.

The effective interest rate can be obtained by

dividing the nominal interest rate by the number of
interest payments per year (M)

i = (r/M)
where:

i = effective interest rate for the period

r = nominal annual interest rate

When Interest Periods Coincide with

Payment Periods

When this occurs, it is possible to directly use

the equations and tables from previous
discussions (annual compounding)
Provided that:

1.

the interest rate (i) is the effective rate for the

period

2.

the number of years (n) must be replaced by the

total number of interest periods (mn), where
m equals the number of interest periods per year

When Interest Periods Coincide with

Payment Periods
Example: An engineer plans to borrow $3,000
from his company credit union, to be
repaid in 24 equal monthly installments.
The credit union charges interest at the
rate of 1% per month on the unpaid
balance. How much money must the
engineer repay each month?

i (1 i ) N
A = P (A/P, i, mn) = P

N
(1 i ) 1

A = ($3000) (A/P, 1%, 24) = $141.20

When Interest Periods Coincide with Payment

Periods
Example:
An engineer wishes to purchase an $80,000 lakeside lot
(real estate) by making a down payment of $20,000 and
borrowing the remaining $60,000, which he will repay on a
monthly basis over the next 30 years. If the bank charges
interest at the rate of 9% per year, compounded monthly,
how much money must the engineer repay each month?

i = (r/m) = (0.095/12) = 0.00792 (0.79%)

N

i
(
1

i
)
A = P (A/P, i, mn) = P

N
(
1

i
)

A = ($60000) (A/P, 0.79%, 360) = $504.50

(Effective Interest Rate) Calculate Auto Loan

Payment

Suppose you want to buy a car. the information as shown

in below caught your attention.

8.5% Annual Percentage Rate! (8.5% compounded

monthly)

48-month financing

Total Purchase price = $22,678.95. You can afford to

make a down payment of $2,678.95, so the net amount to
be financed is $20,000.

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(Effective Interest Rate) Calculate Auto

Loan Payment (cont)

a) What would the monthly payment be? (Answer:$492.97)

(Hint: A= P(A/P, i%, N)

b) After the 25th payment, you want to pay off the

remaining loan in a lump-sum amount. What is the
required amount of this lump sum? (Answer: $10,428.96)
(Hint: B25 = A(P/A, i%, N)

Tutorial - Credit Card

Suppose that you owe $2,000 on a credit card

that charges 18% APR, and you make either
the minimum 10% payment or $200, whichever
is larger, every month. How long will it take to
pay off debt?

Solution

Given APR = 18% (or 1.5% per month), beginning balance = $2,000,
and monthly payment = 10% of outstanding balance.

Find: Number of months to pay off the loan, assuming that no new
purchases are made during this payment period.

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Tutorial: Housing Loan Repayment

Suppose you secure a home improvement
loan in the amount of $5,000 from a local bank.
The loan officer gives you the following loan
terms:

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Contract amount = $5,000

Contract period = 24 months
Annual percentage rate = 12%
Monthly installment = $235.37 (How?).
Construct the loan payment schedule by
showing the remaining balance, interest
payment, and principal payment at the end of
each period over the life of the loan.
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Interest Can Be Compounded

Continuously

Interest is typically compounded at the end of

discrete periods.

In most companies cash is always flowing, and

should be immediately put to use.

We can allow compounding to

continuously throughout the period.

The effect of this compared to discrete

compounding is small in most cases.

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Varying Payment and Compounding

Intervals

Thus far, problems involving time value of money

have assumed annual payments and interest
compounding periods

In most financial transactions and investments,

interest compounding and/or revenue/costs
occur at frequencies other than once a year
(annually)

An infinite spectrum of possibilities, sometimes

called discrete, periodic compounding

In reality, the economics of project feasibility are

simply complex annuity problems with multiple
receipts & disbursements

Continuous Compounding

Continuous Compounding
where the nominal annual interest rate is held
constant at r, the number of interest periods
becomes infinite, and the length of each
interest period becomes infinitesimally small.

The effective annual interest rate in continuous

compounding is expressed by the following
equation:

i = limm[(1 + r/m)m 1] = er - 1

Example: 8% compounded continuously

Payment Period = Quarter
Interest Period = Continuously
1st Q

2nd Q

3rd Q

4th Q

interest periods

Given r = 8%,
M = 4 payments per year

i er / m 1
e 1
2.0201% per quarter
0.02

Continuous compounding interest factors.

For single cash flow

For uniform series (annuities)

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Continuous Compounding
Example: A savings bank is selling long-term
savings certificates that pay interest at the rate of
7 % per year, compounded continuously. What
is the actual annual yield of these certificates?

i = er 1 = e0.075 1 = 0.0779 (7.79%)

Continuous Compounding (Discrete

payments)
Example: A savings bank offers long-term savings
certificates at 7 % per year, compounded
continuously.
If a 10-year certificate costs
$1,000, what will be its value upon maturity?
F = P x(F/P,r,n) = P x ern
F = ($1,000) x e(0.075)(10) = $2,117

Continuous Compounding (Discrete payments)

If interest is compounded continuously but payments are

made (x) times per year, the previous formulas remain
valid as long as r is replaced by r/x and with n being
replaced by nx.

Example: A person borrows $5,000 for 3 years, to be repaid

in 36 equal monthly installments. The interest rate is 10%
per year, compounded continuously. How much must be
repaid at the end of each month?
(A/P,r/x,nx) = (A/P,10/12,36)
A = (P) [(er 1) / (1 e-rn)]
= ($5,000) [(e0.10/12 1) / (1 e-(0.10/12)(12x3))]
= $161.40

Continuous Compounding (Interest for

Continuous Compounding and Discrete Cash
Flow)

Suppose that one has a present loan of

$1000 and desires to determine what
equivalent uniform end-of-year payments, A,
could be obtained from it for 10 years if the
nominal interest rate is 20% compounded
continuously (M=)

Answer: A= $256

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Continuous Compounding (Interest for

Continuous Compounding and Discrete Cash
Flow)

An individual needs $12,000 immediately as a down

payment on a new home. Suppose that he can
borrow this money from his insurance company. He
must repay the loan in equal payments every six
months over the next eight years. The nominal
interest rate being charged is 7% compounded
continuously. What is the amount of each payment?

Answer: A= $997

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