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03-Interest Rate

The document discusses interest rates and time value of money concepts. It defines nominal and effective interest rates, and how to calculate effective rates from nominal rates when the compounding period is less than one year. It also summarizes different ways to express interest rates and how to handle varying interest rates over time when calculating present and future values.

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hilyaulia
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50 views9 pages

03-Interest Rate

The document discusses interest rates and time value of money concepts. It defines nominal and effective interest rates, and how to calculate effective rates from nominal rates when the compounding period is less than one year. It also summarizes different ways to express interest rates and how to handle varying interest rates over time when calculating present and future values.

Uploaded by

hilyaulia
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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INTEREST RATE

After this class the students should be able to:

• Define the interest rate for calculating the time value of


money.
• Contrast nominal and effective rate.

syamsul irham
TIME VALUE OF MONEY
The terms ‘nominal’ and ‘effective’ enter into consideration when the
compounding period (i.e. interest period) is less than one year.

A nominal interest rate(r) is obtained by multiplying an interest rate that is expressed


over a short time period by the number of interest periods in a longer time period:

nominal rate, r = interest rate per period x no. of periods

For example, if i = 1% per month, the nominal rate per year , r , is (1)(12) = 12%/yr

Since nominal rates are essentially simple interest rates, they cannot be used
in any of the interest formulas (effective rates must be used, as calculated below).

Effective rates can be obtained from nominal rates via the following formula:

i = (1 + r /m )m – 1 where m = no times interest is comp’d

For example, if i = 1% per month, effective i/yr = (1 + 0.12/12)12 –1 = 12.68%


syamsul irham
TIME VALUE OF MONEY
There are 3 general ways to express interest rates as shown below:

Interest Rate Statement Comment


i = 12% per month When no compounding period is
(1)
i = 12% per year given, rate is effective

When compounding period is given


(2) i = 10% per year, comp’d semiannually
i= 3% per quarter, comp’d monthly and it is not the same as period of
interest rate, it is nominal

i = effective 10%/yr, comp’d semiannually When compounding period is given


(3) and rate is specified as effective,
i = effective 4% per quarter, comp’d monthly
rate is effective over stated period

syamsul irham
TIME VALUE OF MONEY
Nominal rates can be converted into effective rates via the following equation:

i = (1 + r / m)m – 1
Where : i = effective interest rate for any time period
r = nominal rate for same time period as i
m = no. times interest is comp’d in period specified for i

Example: For an interest rate of 1.2% per month, determine the nominal
and effective rates (a) per quarter, and (b) per year

Solution:
(a) Nominal r / quarter = (1.2)(3) = 3.6% per quarter
Effective i / quarter = ( 1 + 0.036/ 3)3 – 1 = 3.64% per quarter

(b) Nominal i /yr = (1.2)(12) = 14.4% per year


Effective i / yr = (1 + 0.144 / 12)12 – 1 = 15.39% per year
syamsul irham
TIME VALUE OF MONEY
For problems involving single amounts, the payment period(PP) is usually
longer than the comp’d period(CP). For these problems, there are an infinite
number of i and n combinations that can be used, with only two restrictions:

(1) The i must be an effective interest rate, and


(2) The time units on n must be the same as those of i ( if i is a rate
per quarter, then n must be the no. of quarters between P and F)

Example: How much money will be in an account in 5 years if $10,000 is


deposited now at an interest rate of 1% per month? Use three different rates:
(a) monthly, (b) quarterly , and (c) yearly.

(a) For monthly rate, 1% is effective:


F = 10,000(F/P,1%,60) = $18,167
(b) For a quarterly rate, effective i/quarter = (1 + 0.03/3) 3 –1 = 3.03%
F = 10,000(F/P,3.03%,20) = $18,167
(c) For an annual rate, effective i/yr = (1 + 0.12/12)12 –1 = 12.68%
F = 10,000(F/P,12.68%,5) = $18,165
syamsul irham
TIME VALUE OF MONEY
For series cash flows, first step is to determine relationship between PP and CP

When PP>=CP, the only procedure(2 steps) that can be used is as follows:

(1) First, find effective i per PP (ex: if PP is quarters, must find effective i/quarter
(2) Then, determine n, where n is equal to the no. of A values involved (ex: quarterly
payments for six years yields n = 24)

Example: How much money will be accumulated in 10 years from a deposit


of $500 every 6 months if the interest rate is 1% per month?

Solution: Since PP>CP, first step is to find effective i per PP (six months):
i /6 mos. = (1 + 0.06 /6)6 – 1 = 6.15%

Next step is to determine n:


n = 10(2) = 20
Now, F = 500(F/A,6.15%,20)
= $18,692 (Excel)
When PP<CP, no interperiod compounding is assumed. Therefore, withdrawals
are moved to beginning of interest period in which they occur and deposits to end.

[ This condition (i.e. PP<CP) is the only time the actual cash flow diagram is changed]

Example: A person deposits $100 per month into a savings account for 2 years. If
$75 is withdrawn in months 5,7 and 8 (in addition to the deposits), how much will
be in the account after 2 years at i = 6% per year, comp’d quarterly.

Solution: Since PP<CP, the cash flow diagram must be changed as follows:
75 7575 F=? 75 150 F=?
from 0 1 2 3 4 5 6 7 8 9 10 23 24 to 0 1 2 3 4 5 6 7 8 9 10 21 24 months
1 2 3 7 8 quarters
this this
100 300 300 300 300 300

F = 300(F/A,1.5%,8) – 75(F/P,1.5%,7) - 150 (F/P,1.5%,6)


= $2,283
When the interest period is infinitely small, interest is comp’d continuously

For continuous compounding, equation is: i = er – 1 PP>CP

Example: If a person deposits $500 into an account every 3 months for


five years at an interest rate of 6% per year compounded continuously,
how much will be in the account at the end of that time?

Solution: Nominal rate,r, per three months is 1.5%. Therefore,


Effective i/ 3 months = e0.015 – 1 = 1.51%

F = 500(F/A,1.51%,20)
= $11,573
When interest rates vary over time, use the interest rates associated with their
respective time periods to find P.

Example: Find the present worth of a uniform series of $2500 deposits in years
1 thru 8 if the interest rate is 7% for the first five years and 10% per year thereafter.

Solution: P = 2,500(P/A,7%,5) + 2,500(P/A,10%,3)(P/F,7%,5)


= $14,683

An equivalent AW value can be obtained by replacing each cash flow amount


with ‘A’ and setting the equation equal to the calculated P value as follows:

14,683 = A(P/A,7%,5) + A(P/A,10%,3)(P/F,7%,5)


A = $2500

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