Lecture Notes 3
Summer 2021, GENG 204 – Engineering Economics, Phoenicia University, Dr. Abou Kasm
Reference: Chapter 4 in Blank, L. and A. Tarquin (2012). Engineering Economy, 7th Edition,
McGraw-Hill, Inc
Nominal and effective interest rates
12% per year compounded monthly
Nominal rate: 12%
o Called APR (annual percentage rate)
o Does not account for compounding
0.12 12
Effective rate: 𝑖𝑎 = (1 + ) − 1 = 12.68%
12
o Called APY (annual percentage yield)
o Accounts for compounding
Effective Annual Interest rates
Parameters
o CP: time period for each compounding
o m: number of compounding periods per year
o r: nominal rate per year
o 𝑖: effective interest rate per compounding period
o 𝑖𝑎 : effective interest rate per year
Equations
𝒓
o 𝑖=
𝒎
𝑟
o 𝑖𝑎 = (1 + 𝑖)𝑚 − 1 = (1 + )𝑚 − 1
𝑚
Examples
o r = 18%/year compounded weekly
CP = 1 week
m = 52
0.18 52
𝑖𝑎 = (1 + ) − 1 = 19.68%
52
o r = 18%/year compounded quarterly
CP = 3 months
m=4
0.18 4
𝑖𝑎 = (1 + ) − 1 = 19.25%
4
Exercise: Consider a cash flow with $5000/year payments for 5 years. Interest rate is
12%/year compounded semi-annually. What is the balance at EOY 5 if we start payments
today?
0.12 2
CP = 6 months, m=2, 𝑖𝑎 = (1 + ) − 1 = 12.36% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
2
𝐹𝐸𝑂𝑌5 = 5000(𝐹|𝐴, 12.36,5)(𝐹|𝑃, 12.36, 1) = ⋯
Example (PP = CP): $2500 payments every 6 months for 3 years. What is the balance at
EOY5 if the interest rate is 12%/year compounded semi-annually?
Payment period (PP) = 6 months, compounding period (CP) = 6 months (m = 2) PP =
CP
i/CP = i/6 months = 12/m = 12/2 = 6% per 6 months
𝐹𝐸𝑂𝑌5 = 2500(𝐹|𝐴, 6, 6)(𝐹|𝑃, 6, 4) = ⋯
OR
0.12 2
𝑖𝑎 = (1 + ) − 1 = 12.36% 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
2
𝐹𝐸𝑂𝑌5 = 2500(𝐹|𝐴, 6, 6)(𝐹|𝑃, 12.36, 2) = ⋯
Payment Period less than Compounding Period (PP < CP)
o NO interperiod compounding:
Use i/CP
Deposits assumed to be at the end of the CP
Withdrawals assumed to be at the beginning of CP
Ex: Banks may not give interest on amounts withdrawn before end of CP
Example (based on 4.11) Draw a new cash flow given that the interest rate is
compounded quarterly. Then use i=12%/year compounded quarterly to calculate the
future equivalent value at the end of the year. Assume no interperiod compounding.
Given:
New cash flow:
i = 12/m = 12/4 =3% per quarter
F = -150 (F/P, 3, 4) – 200 (F/P, 3, 3) + (-175 + 180)(F/ P, 3, 2) + 165 (F/P, 3, 1) – 50 = $-262.11
Payment Period not equal to Compounding Period (PP ≠ CP ≠ 1 year)
o Includes interperiod compounding
o Explained through example: i = 10%/year compounded monthly, quarterly
payments ($1000 each) for 4 years. What is your balance at EOY4?
Step 1: PP = 1 quarter = 3 months
CP = 1 month
Step 2: m = number of CPs/year = 12
k = number of PPs/year = 4
c = m/k = 3
𝑖 𝑐
Step 3: i/pp = (1 + ) − 1
𝑚
0.1 3
= (1 + ) − 1 = 2.52% per PP (3 months)
12
Cash flow and calculation: FEOY4 = 1000 (F/A, 2.52, 16)
Example (repeat example 4.11 but with interperiod compounding)
i = 12% per year compounded quarterly
Use i/pp = i/month
Step 1: PP= 1 months, CP = 3 months
Step 2: m = 4, k = 12, c = 4/12 = 1/3
1
𝑖 𝑐 0.12 3
Step 3: i/month = i/PP = (1 + ) − 1 = (1 + ) − 1 = 0.99016 %
𝑚 4
F = -150(F/P, 0.99016%, 12) - 200(F/P, 0.99016%, 10) - 75(F/P, 0.99016%, 8) - (F/P, 0.99016%,
7) + 90(F/A, 0.99016%, 2) (F/P, 0.99016%, 4) + 120(F/P, 0.99016%, 3) - 50(F/P, 0.99016%, 2)
+ 45(F/P, 0.99016%, 1) = …
NOTE: i/CP can be used on cash flows that occur on the compounding period.
For example: $120 at year 9 can be taken to the future in two ways:
i) F = 120(F/P, 0.99016%, 3) = $123.6
ii) F = 120(F/P, i/CP, 1) = 120(F/P, 3%, 1) = $123.6
Exercise
To start a business you need $20,000 now and payments of $5000/month for 1 year. At the end
of the 2nd year, your decorator will be asking for quarterly payment of $3000/ quarter until EOY
3. How much would you estimate your expenses now? i = 12%/year compounded monthly.
i/cp = 12/12 = 1% /month
i/quarter = ?
Step 1: PP= 3 months, CP = 1 month
Step 2: m = 12, k = 4, c = 3
Step 3: i/quarter = i/PP = 3.03%
Ptot = 20000 + 5000 (P/A, 1, 12) + 3000 (F/A, 3.03, 5)(P/F, 1, 36) = …
Continuous compounding
CP infinitely small and m becomes infinite
Often assumed in quantitative finance to simplify calculations
𝑟
𝑟 𝑚 1 ℎ𝑟 1 ℎ
lim 𝑖 = lim (1 + ) − 1 = lim (1 + ) − 1 = lim [(1 + ) ] − 1
𝑚→ ∞ 𝑚→ ∞ 𝑚 ℎ→ ∞ ℎ ℎ→ ∞ ℎ
1 ℎ
We know: lim (1 + ) = 𝑒 = 2.71828
ℎ→ ∞ ℎ
𝑖 = 𝑒𝑟 − 1
Example 4.12(a): For an interest rate of 18% per year, compounded continuously,
calculate the effective monthly and annual interest rates.
nominal monthly rate, r = 18/12 = 1.5% per month i = 𝑒 0.015 − 1= 1.51% per month
nominal annual rate, r = 18 % per year i = 𝑒 0.18 − 1= 19.72% per year
Example 4.12(b): An investor requires an effective return of at least 15%. What is the
minimum annual nominal rate that is acceptable for continuous compounding?
𝑖 = 𝑒𝑟 − 1
0.15 = 𝑒 𝑟 − 1
𝑒 𝑟 = 1.15
ln 𝑒 𝑟 = ln 1.15
𝑟 = 0.13976 = 13.976 % 𝑝𝑒𝑟 𝑦𝑒𝑎𝑟
Example 4.13: Engineers Marci and Suzanne both invest $5000 for 10 years at 10% per
year. Compute the future worth for both individuals if Marci receives annual
compounding and Suzanne receives continuous compounding
Marci: F = P (F/P, 10%, 10) = 5000(2.5937) = $12,969
Suzanne: i = 𝑒10 − 1 = 10.517% F = P (F/P, 10.517%, 10) = 5000(2.7183) = $13591
Example 4.14
Determine present worth and equivalent uniform series for the following cash flows:
P = 70,000 (P/A, 7%, 2) + 35,000 (P/F, 9%, 1)(P/F, 7% , 2) + 25,000 (P/F, 10%, 1)(P/F, 9%,
1)(P/F, 7% , 2) = …
P = A [ (P/A, 7%, 2) + (P/F, 9%, 1)(P/F, 7% , 2) + (P/F, 10%, 1)(P/F, 9%, 1)(P/F, 7% , 2) ]
