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Mcgraw-Hill, Inc: Lecture Notes 3

The document discusses different types of interest rates including nominal rates, effective rates, and continuous compounding rates. It provides equations to calculate effective interest rates given nominal rates and compounding periods. Examples are given to demonstrate calculating effective annual rates, rates with different payment and compounding periods, and continuous compounding rates. The document concludes with an example of determining present worth and equivalent uniform series for a cash flow problem.

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Hassan Shehadi
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63 views

Mcgraw-Hill, Inc: Lecture Notes 3

The document discusses different types of interest rates including nominal rates, effective rates, and continuous compounding rates. It provides equations to calculate effective interest rates given nominal rates and compounding periods. Examples are given to demonstrate calculating effective annual rates, rates with different payment and compounding periods, and continuous compounding rates. The document concludes with an example of determining present worth and equivalent uniform series for a cash flow problem.

Uploaded by

Hassan Shehadi
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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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) ]

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