(
= +
(
=
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
SinglePayment 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
SinglePayment Transactions with Continuous
Compounding Present Worth
F
0
N
P
(1 )
(1 1)
N
r N
rN
P F i
F e
Fe
= +
= +
=
ContinuousFunds 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: A15month 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
Fixedrate mortgage
Adjustablerate 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 fiveyear
interestonly option.
(a) Monthly payments.
(b) Interest payments:
Contemporary Engineering Economics, 5th edition, 2010
Calculating the Monthly Payments with
AdjustableRate 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 10year ownership
Monthly payments under 5/1 Hybrid mortgage
Contemporary Engineering Economics, 5th edition, 2010
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