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Understand nominal and effective Interest


rates statements
Determine equivalence calculations for
different payment and compounding
periods
How commercial loans and mortgages are
structured in terms of interest and
principal payments.
The basic of investing in financial assets
Nominal Versus Effective Interest Rates
Nominal Interest
Rate:
Interest rate quoted
based on an annual
period.
(Annual percentage
rate-APR)

Effective Interest
Rate:
Actual interest earned
or paid in a year or
some other time
period


Ex: 18% compounded
monthly
12 12
$1(1 ) $1(1 0.015)
$1.1956
$1.1956 $1.00 $0.1956
F i
I
= + = +
=
= =

Effective Annual Interest Rate (Yield)
Formula:



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

Example:
18% compounded
monthly


What It really Means
1.5% per month for 12
months or
19.56% compounded
once per year

(1 ) 1
M
a
r
i
M
= +
12
0.18
1 1 19.56%
12
a
i
| |
= + =
|
\ .
Practice
Problem
Suppose your savings
account pays 9% interest
compounded quarterly.
(a) Interest rate per
quarter
(b) Annual effective
interest rate (i
a
)
(c) If you deposit
$10,000 for one year,
how much would
you have?

Solution:

Contemporary Engineering Economics, 5th edition, 2010
4
(a) Interest rate per quarter:
9%
2.25%
4
(b) Annual effective interest rate:
(1 0.0225) 1 9.31%
(c) Balance at the end of one year (after 4 quarters)
$10,000( / ,2.
a
i
i
F F P
= =
= + =
= 25%,4)
$10,000( / ,9.31%,1)
$10,931
F P =
=
Contemporary Engineering Economics, 5th edition, 2010
Nominal and Effective Interest Rates with
Different Compounding Periods
Effective Rates
Nominal
Rate
Compounding
Annually
Compounding
Semi-annually
Compounding
Quarterly
Compounding
Monthly
Compounding
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
Why Do We Need an Effective Interest Rate
per Payment Period?
Contemporary Engineering Economics, 5th edition, 2010
Payment period
Interest period
Payment period
Interest period
Whenever payment and compounding periods differ from
each other, one or the other must be transformed so that
both conform to the same unit of time.
Effective Interest
Rate per Payment
Period (i)
Formula:




C = number of
interest periods per
payment period
K = number of
payment periods per
year
CK = total number of
interest periods per
year, or M
r/K = nominal interest
rate per payment period
Functional Relationships among r, i, and i
a
, where
interest is calculated based on 9% compounded
monthly and payments occur quarterly
Contemporary Engineering Economics, 5th edition, 2010
1 1
C
r
i
CK
| |
= +
|
\ .
Effective Interest Rate per
Payment Period with
Continuous Compounding
Formula: With continuous
compounding


Example: 12% compounded
continuously
(a) effective interest rate per quarter



(b) effective annual interest rate


Contemporary Engineering Economics, 5th edition, 2010
C
/
lim 1 1
1
r K
C
C
r
i
CK
e

(
= +
(

=

0.12/4
1
3.045% per quarter
i e =
=
0.12/1
1
12.75% per year
a
i e =
=
Contemporary Engineering Economics, 5th edition, 2010
Case 0: 8% compounded quarterly
Payment Period = Quarter
Interest Period = Quarterly

1 interest period
Given r = 8%,
K = 4 payments per year
C = 1 interest period per quarter
M = 4 interest periods per year
2
nd
Q 3
rd
Q 5th Q
1
st
Q
1
[1 / ] 1
[1 0.08 / (1)(4)] 1
2.000% per quarter
C
i r CK = +
= +
=
Contemporary Engineering Economics, 5th edition, 2010
Case 1: 8% compounded monthly
Payment Period = Quarter
Interest Period = Monthly

3 interest periods
Given r = 8%,
K = 4 payments per year
C = 3 interest periods per quarter
M = 12 interest periods per year
2
nd
Q 3
rd
Q 5th Q
1
st
Q
3
[1 / ] 1
[1 0.08 / (3)(4)] 1
2.013% per quarter
C
i r CK = +
= +
=
Contemporary Engineering Economics, 5th edition, 2010
Case 2: 8% compounded weekly
Payment Period = Quarter
Interest Period = Weekly

13 interest periods
Given r = 8%,
K = 4 payments per year
C = 13 interest periods per quarter
M = 52 interest periods per year
2
nd
Q 3
rd
Q 5th Q
1
st
Q
i r CK
C
= +
= +
=
[ / ]
[ . / ( )( )]
.
1 1
1 0 08 13 4 1
2 0186%
13
per quarter
Contemporary Engineering Economics, 5th edition, 2010
Case 3: 8% compounded continuously
Payment Period = Quarter
Interest Period = Continuously

interest periods
Given r = 8%,
K = 4 payments per year

2
nd
Q 3
rd
Q 5th Q
1
st
Q
/
0.02
1
1
2.0201% per quarter
r K
i e
e
=
=
=
Contemporary Engineering Economics, 5th edition, 2010
Summary: Effective Interest Rates per Quarter at
Varying Compounding Frequencies
Case 0 Case 1 Case 2 Case 3
8%
compounded
quarterly
8%
compounded
monthly
8%
compounded
weekly
8%
compounded
continuously
Payments occur
quarterly
Payments occur
quarterly
Payments occur
quarterly
Payments occur
quarterly
2.000% per
quarter
2.013% per
quarter
2.0186% per
quarter

2.0201% per
quarter
Contemporary Engineering Economics, 5th edition, 2010

Equivalence Analysis Using Effective Interest Rates.
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!
When payment period and compounding
period differ, calculate an effective interest
rate that covers the payment period. Then
use the appropriate interest formulas to
determine the equivalent values
Equivalence Calculations using Effective
Interest Rates
Step 1: Identify the payment period (e.g., annual,
quarter, month, week, etc)

Step 2: Identify the compounding 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
Calculating Auto Loan Payments

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)

Contemporary Engineering Economics, 5th edition, 2010
Suppose you want to buy a car. You have surveyed the dealer newspaper
advertisements, and the following one has caught your attention:
Given:
P = $15,000, r = 6.25
n = 72 months, M = 12 int
period per year.
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 =
Compounding Occurs More Frequently than Payments are Made .
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









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
| |
= +
|
\ .
=
Suppose you make equal quarterly deposits of $1500 into a fund that
pays interest at a rate of 6% compounded monthly. Find the balance
at the end of year 2.
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










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
| |
= +
|
\ .
=
Suppose you made $500 monthly deposits to a retirement plan that pays
interest at a rate of 10% compounded quarterly . Compute the balance at the
end of 10 years. Interest is accrued on deposits made during the cp.
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
F
0
N
P
Single-Payment Transactions with
Continuous Compounding Future Worth
(1 )
(1 1)
N
r N
rN
F P i
P e
Pe
= +
= +
=
Practice
Problem
If you invest
$1,000 in a savings
account that pays
6% annual interest
compounded
continuously, what
would be the
balance at the end
of 3 years?

Contemporary Engineering Economics, 5th edition, 2010
0.06
1
6.18%
$1, 000( / , 6.18%, 3)
$1,197.09
a
i e
F F P
=
=
=
=
Contemporary Engineering Economics, 5th edition, 2010
Single-Payment Transactions with Continuous
Compounding Present Worth

F
0
N
P
(1 )
(1 1)
N
r N
rN
P F i
F e
Fe

= +
= +
=
Continuous-Funds Flow
Contemporary Engineering Economics, 5th edition, 2010
| |
0
0
( )
( )
rt
t
N
rt
P f t t e
f t e dt

= A
=

}
Exercise: Daily Flows and Daily Compounding with Continuous
Flows and Continuous Compounding
Consider a situation in which money flows daily.
Suppose you own a retail shop and generate $200
cash each day. You establish a special business
account and deposit your daily cash flows in an
account for 15 months. This account earns an
interest rate at 6%. Compare the accumulated cash
values at the end of 15 months a) daily compounding
b) Continuous compounding.
Contemporary Engineering Economics, 5th edition, 2010
Given: A = $200 per
day, r = 6% per year, M =
365 compounding
periods per year, and N =
455 days

Find: F
Solution

Contemporary Engineering Economics, 5th edition, 2010
Note: A15-month period
Is 1.25 years.
Example 4.12 Loan
Balance, Principal, and
Interest: Tabular
Approach
Given: P = $5,000, i = 12% APR,
N = 24 months

Find: A, and loan repayment
schedule

A = $5,000(A/P, 1%, 24) = $235.37



Contemporary Engineering Economics, 5th edition, 2010
Calculating the Remaining Loan Balance after
Making the nth Payment
Contemporary Engineering Economics, 5th edition, 2010
Example 4.13 Loan
Balance, Principal, and
Interest: Remaining
Balance Method

Given: P = $5,000, i = 12%
APR, N = 24 months

Find: Loan balance, principal,
and interest payment for the 6
th

payment


A = $5,000(A/P, 1%, 24) = $235.37



Contemporary Engineering Economics, 5th edition, 2010
Example 4.15 Financing your Vehicle
Given: Three financing options, r = 4.5%, payment
period = monthly, and compounding period =
monthly
Find: Which option?

Issue: Which interest rate to use in calculating the
equivalent cost of financing for each option





Option A: Conventional Debt Financing:

P
debt
= $4,500 + $736.53(P/A, 4.5%/12, 42)
- $17,817(P/F, 4.5%/12, 42)
= $17,847

Option B: Cash Financing:

P
cash
= $31,020 - $17,817(P/F,4.5%/12,42)
= $15,845

Option C: Lease Financing:

P
lease
= $1,507.76 + $513.76(P/A, 4.5%/12, 42)
+ $395(P/F, 4.5%/12, 42)
= $21,336

Contemporary Engineering Economics, 5th edition, 2010
Home Mortgage
Types of Home Mortgages The Cost of a Mortgage
Fixed-rate mortgage
Adjustable-rate mortgage
Hybrid Mortgage
Loan amount
Loan term
Payment frequency
Points (prepaid interest)
Fees
Types of mortgages
Contemporary Engineering Economics, 5th edition, 2010
Example 4.16 An Interest-
Only versus a Fully
Amortized Mortgage
Given: P = $200,000, APR =
6.6% or 0.55% per month, and
N = 30 years
Find: (a) monthly payment;
(b) interest payments during
the first year of ownership of
the home.
Option 1: A fully
amortized payment option.
Option 2: A five-year
interest-only option.
(a) Monthly payments.

(b) Interest payments:
Contemporary Engineering Economics, 5th edition, 2010
Calculating the Monthly Payments with
Adjustable-Rate Mortgage (ARMs)
Index a guide that lenders use to
measure interest rate changes
Margin an interest rate that
represents the lenders cost of doing
business plus the profit
Adjustment period the period
between potential interest rate
adjustments (e.g., 3/1 means your
interest rate is fixed for the first 3
years then could be adjusted every
year thereafter.)
Interest rate cap a limit on the
amount your interest can change (a
periodic cap and a lifetime cap)
Payment cap how much your
monthly payment can increase at
each adjustment
Contemporary Engineering Economics, 5th edition, 2010
Example 4.18 A 5/1
Hybrid Adjustable
Mortgage Plan
Given: Varying annual mortgage
rates and N = 30 years






Find: (a) the monthly payment;
(b) the total interest payment over
the 10-year ownership
Monthly payments under 5/1 Hybrid mortgage

Contemporary Engineering Economics, 5th edition, 2010