Multiple Compounding

Periods in a Year
Example: credit card debt

Principles of Engineering Economic Analysis, 5th edition

 Example 2.36
Rebecca Carlson purchased a car for $25,000 by borrowing
the money at 8% per year compounded monthly. She paid
off the loan with 60 equal monthly payments, the first of
which was paid one month after receiving the car. How
much was her monthly payment?

A = $25,000(A|P ⅔%,60) = $25,000(0.02028) = $507.00

A =PMT(0.08/12,60,-25000)
A = $506.91

Principles of Engineering Economic Analysis, 5th edition

 Compounding and Timing
 To date, we have assumed the frequency with which interest
was compounded matched the frequency of payments and
deposits.
 This is not always the case, e.g., monthly deposits and annual
compounding, annual compounding and bi-annual deposits.
The effective annual interest rate (ieff) is used to deal with
differences in the timing of cash flows and the compounding
frequency.
m
 r  r% 
ieff  1    1  F | P , m  1
 m  m 
 r = nominal annual interest rate
 m = number of compound periods per year
 ieff =EFFECT(r,m)

Principles of Engineering Economic Analysis, 5th edition

 Example 2.37
 What is the effective interest rate for 12% per annum
compounded annually?
r = 12%, m = 1, r/m = 12%
ieff = (F|P 12%,1)-1 = 1.1200-1.0 = 12.00%
=EFFECT(12%,1) = 12%

 What is the effective interest rate for 12% per annum

compounded semiannually?
r = 12%, m = 2, r/m = 6%
ieff = (F|P 6%,2)-1 = 1.1236-1.0 = 12.36%
=EFFECT(12%,2) = 12.36%

Principles of Engineering Economic Analysis, 5th edition

 Example 2.37
 What is the effective interest rate for 12% per annum
compounded quarterly?
r = 12%, m = 4, r/m = 3%
ieff = (F|P 3%,4)-1 = 1.12551-1.0 = 12.551%
=EFFECT(12%,4) = 12.551%

 What is the effective interest rate for 12% per annum

compounded monthly?
r = 12%, m = 12, r/m = 1%
ieff = (F|P 1%,12)-1 = 1.12683-1.0 = 12.683%
=EFFECT(12%,12) = 12.683%

Principles of Engineering Economic Analysis, 5th edition

 Example 2.37
 What is the effective interest rate for 12% per annum
compounded weekly?
r = 12% m = 52,
ieff = (1 + 0.12/52)52 -1 = 1.1273409872 - 1.0
= 12.73409872%
=EFFECT(12%,52) = 12.73409872%
 What is the effective interest rate for 12% per annum
compounded daily?
r = 12% m = 365
ieff = (1 + 0.12/365)365 -1 = 1.1274746156 - 1.0
= 12.74746156%
=EFFECT(12%,365) = 12.74746156%

Principles of Engineering Economic Analysis, 5th edition

 Example 2.37
 What is the effective interest rate for 12% per annum
compounded hourly?
r = 12% m = 8760,
ieff = (1 + 0.12/8760)8760 -1 = 1.1274959248782 - 1.0
= 12.74959248782%
=EFFECT(12%,8760) = 12.74959248776%
 What is the effective interest rate for 12% per annum
compounded every minute?
r = 12% m = 525,600,
ieff = (1 + 0.12/525,600)525,600 -1 = 1.127496836146 - 1.0
= 12.7496836146%
=EFFECT(12%,525600) = 12.7496836133%

Principles of Engineering Economic Analysis, 5th edition

 Example 2.37
 What is the effective interest rate for 12% per annum
compounded every second?
r = 12% m = 31,536,000
ieff = (1 + 0.12/31,536,000)31,536,000 -1 = 1.127496851431 - 1.0
= 12.7496851431%
=EFFECT(12%,31536000) = 12.7496852242%

 What is the effective interest rate for 12% per annum

compounded continuously?
r = 12% m = infinitely large
From Appendix 2A, we’ll find that
ieff = e0.12 – 1 = 12.7496851579%

Principles of Engineering Economic Analysis, 5th edition

 Shorthand Notation
 In some end-of-chapter problems in subsequent
chapters, we use a shorthand notation when
money is compounded multiple times per year.

 For example,
8% per annum compounded quarterly is denoted
8%/year/quarter
and
12% per annum compounded monthly is denoted
12%/year/month.

Principles of Engineering Economic Analysis, 5th edition

 Example 2.38
Wenfeng Li borrowed $1,000 and paid off the loan in
4.5 years with a single lump sum payment of $1,500.
Based on a 6-month interest period, what was the
annual effective interest rate paid?

Principles of Engineering Economic Analysis, 5th edition

 Example 2.38
Wenfeng Li borrowed $1,000 and paid off the loan in
4.5 years with a single lump sum payment of $1,500.
Based on a 6-month interest period, what was the
annual effective interest rate paid?

n = 9 (6-mo periods), P = $1,000, F = $1,500, i = ?

$1,500 = $1,000(F|P i%,9)
(1 + i)9 = 1.5
i = 0.046 or 4.6%
ieff = (1 + 0.046)2 – 1 = 0.0943 or 9.43%

Principles of Engineering Economic Analysis, 5th edition

 Example 2.38
Wenfeng Li borrowed $1,000 and paid off the loan in
4.5 years with a single lump sum payment of $1,500.
Based on a 6-month interest period, what was the
annual effective interest rate paid?

n = 9 (6-mo periods), P = $1,000, F = $1,500, i = ?

$1,500 = $1,000(F|P i%,9)
(1 + i)9 = 1.5
i = 0.046 or 4.6%
ieff = (1 + 0.046)2 – 1 = 0.0943 or 9.43%
ieff =RATE(4.5,,-1000,1500) = 9.429%
Principles of Engineering Economic Analysis, 5th edition
 Example 2.39
Greg Wilhelm borrowed $100,000 to purchase
a house. It will be repaid with 360 equal
monthly payments at a nominal annual rate of
6% (6%/year/month). Determine the monthly
payments.

A = $100,000(A|P 0.5%,360)
= $100,000(0.0059955)
= $599.55/month
=PMT(0.06/12,360,-100000)
= $599.55

Principles of Engineering Economic Analysis, 5th edition

 Example 2.39
In addition to the usual interest charges, Mr. Wilhelm
had to pay $2,000 in closing costs to the lending firm. If
the closing costs are financed, what would be the size
of the monthly payments?

A = $102,000(A|P 0.5%,360)
= $102,000(0.0059955)
= $611.54/month
=PMT(0.06/12,360,-102000)
= $611.54

Principles of Engineering Economic Analysis, 5th edition

 When Compounding and Cash Flow
Frequencies Differ
When compounding frequency and cash flow frequency differ,
the following approach is taken.

i = (1 + r/m)m/k – 1 (2.49)

r = the nominal annual interest rate for money

m= the number of compounding periods in a year
k = the number of cash flows in a year and;
i = the interest rate per cash flow period.

Equation 2.49 results from setting the effective annual interest rate for the
stated compounding frequency of money equal to the effective annual
interest rate for the cash flow frequency.

(1 + i)k - 1 = (1 + r/m)m -1

and solving for i.

Principles of Engineering Economic Analysis, 5th edition
 Example 2.40
What size monthly payments should occur when $10,000 is
borrowed at 8% compounded quarterly (8%/year/quarter) and
the loan is repaid with 36 equal monthly payments?

From Equation 2.49:

r = 0.08, m = 4, and k = 12. Therefore,
i = (1 + 0.08/4)4/12 – 1 = 0.006623 or 0.6623%/month

Knowing the monthly interest rate, the monthly payment can be

determined,
A = $10,000(A|P 0.6623%,36)
= $10,000[(0.006623)(1.006623)36]/[(1.006623)36 - 1]
= $313.12
Using the Excel® PMT worksheet function,
A =PMT(1.02^(1/3)-1,36,-10000)
= $313.12
Principles of Engineering Economic Analysis, 5th edition
 Summary of discrete compounding interest factors.
To Find Given Factor Symbol Name

P F (1 + i)-n (P|F i%,n ) Single sum, present worth factor

F P (1 + i)n (F|P i%,n ) Single sum, compound amount factor

(1 + i)n - 1
P A (P|A i%,n ) Uniform series, present worth factor
i(1 + i)n

i(1 + i)n
A P (A|P i%,n ) Uniform series, capital recovery factor
(1 + i)n - 1

(1 + i)n - 1
F A (F|A i%,n ) Uniform series, compound amount factor
i

i
A F (A|F i%,n ) Uniform series, sinking fund factor
(1 + i )n - 1

[1 - (1 + ni )(1 + i )-n ]
P G (P|G i%,n ) Gradient series, present worth factor
i2

(1 + i)n - (1 + ni )
A G (A|G i%,n ) Gradient series, uniform series factor
i [(1 + i )n - 1]

1 - (1 + j )n (1 + i )-n
P A 1,j for i ≠ j
(P|A 1 i%,j%,n ) Geometric series, present worth factor
i-j

(1 + i )n - (1 + j) n
F A 1,j for i ≠ j (F|A 1 i%,j%,n ) Geometric series, future worth factor
i-j

Principles of Engineering Economic Analysis, 5th edition

 Pit Stop #2 — Hang On!

1. True of False: If money is worth 5% compounded annually to you, then you

should prefer to receive $2,750 today than to receive $3,500 five years from
today.

2. True or False: If money is worth 7% compounded annually to you, then you

should prefer to receive $1,000,000 thirty years from now than to receive
$200,000 today.

3. True of False: If money is worth 6% compounded annually to you, then you

should prefer to receive $1,750 per year for 5 years than to receive $1,000 per
year for 10 years, assuming the first receipt occurs one year from today in
both cases.

4. True or False: If money is worth 7% compounded annually to you, then you

would prefer to receive $2,200 each year for 5 years than to receive $4,000 the
first year, $3,000 the second year, $2,000 the third year, $1,000 the fourth year,
and $0 the fifth year.

5. True of False: If money has a time value of 8% compounded annually, you

should prefer to receive a uniform series of ten $1,000 cash flows over the
interval [1,10] to receiving a uniform series of ten $1,260 cash flows over the
interval [4,13].

Principles of Engineering Economic Analysis, 5th edition

 Pit Stop #2 — Hang On!
1. True of False: If money is worth 5% compounded annually to you, then you
should prefer to receive $2,750 today than to receive $3,500 five years from
today. True PV(5%,5,,-3500) = $2,742.34 < $2,750.00

2. True or False: If money is worth 7% compounded annually to you, then you

should prefer to receive $1,000,000 thirty years from now than to receive
$200,000 today. False $1,000,000.00 < FV(7%,30,,-200000) = $1,522,451.01

3. True of False: If money is worth 6% compounded annually to you, then you

should prefer to receive $1750 per year for 5 years than to receive $1,000 per
year for 10 years, assuming the first receipt occurs one year from today in both
cases. True PV(6%,5,-1750) = $7,371.64 > PV(6%,10,-1000) = $7,360.09

4. True or False: If money is worth 7% compounded annually to you, then you

would prefer to receive $2,200 each year for 5 years than to receive $4,000 the
first year, $3,000 the second year, $2,000 the third year, $1,000 the fourth year,
and $0 the fifth year. True PV(7%,5,-2200) = $9,020.43 >
NPV(7%,4000,3000,2000,1000) = $8,754.12
5. True of False: If money has a time value of 8% compounded annually, you
should prefer to receive a uniform series of ten $1,000 cash flows over the
interval [1,10] to receiving a uniform series of ten $1,260 cash flows over the
interval [4,13]. False PV(8%,10,-1000) = $6,710.08 <
PV(8%,3,,PV(8%,10,1260)) = $6,711.62
Principles of Engineering Economic Analysis, 5th edition
 Appendix 2A
Continuous Compounding
• In businesses and governments, transactions occur every year,
every month, every day, every hour, every minute, every second!

• In multi-national corporations, for example, money is “put to work”

immediately.

• Via electronic transfers, money is invested around the world

continuously.

• Explicit consideration of “around the clock” and “around the world”

money management motivates the use of continuous
compounding.

Principles of Engineering Economic Analysis, 5th edition

 Continuous Compounding
Let m denote the number of compounding periods in a year, r
denote the nominal annual interest rate, and n denote the
number of years.

The single payment compound amount factor is given by

(1+r/m)mn
Letting the number of compounding periods in a year become
infinitely large, the single payment compound amount factor
reduces to

lim  1  r / m  mn
 e rn

m 
Hence,
F = P ern
F = P (F|P r%, n)
∞
P = F e-rn and
P = F(P|F r%, n)
∞
Principles of Engineering Economic Analysis, 5th edition
 Continuous Compounding
Recall, in discussing effective interest rates we claimed the
effective interest rate for 12% compounded continuously was
12.7496851579%.

The effective interest rate under continuous compounding is

given by:

ieff = er-1 or ieff = (F|P r%,1) - 1

∞

Therefore, the effective interest rate for 12% compounded

continuously is equal to e0.12-1, or 12.7496851579%.

Principles of Engineering Economic Analysis, 5th edition

 Continuous Compounding
For the case of discrete cash flows, the
continuous compounding equivalents for the
discounted cash flow formulas can be obtained
by substituting (er-1) for i.
 P | F r=%,en-rn


 F | P r=%,enrn 
 F | A r=%,(enrn -1)/(er-1)
 A | F =r %,(enr-1)/(e
  rn-1)
 P | A r=%,(enrn -1)/[ern(er-1)]
 A | P r=%,ernn (e
r-1)/(ern-1)

See Table 2.A.1

Principles of Engineering Economic Analysis, 5th edition
 Summary of continuous compounding interest factors for discrete flows.

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.1
If $2,000 is invested in a fund that pays interest at a
rate of 12% compounded continuously, after 5 years
how much will be in the fund?

F = P(F|P 12%,5) = $2,000(1.82212) = $3,644.24

∞

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.2
If $1,000 is deposited annually in an account that pays
interest at a rate of 12% compounded continuously,
after the 10th deposit how much will be in the fund?
F = $1,000(F|A 12%,10)
∞
F = $1,000(18.19744)
F = $18,197.44
F =FV(exp(0.12)-1,10,-1000)
F = $18,197.44

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.2
$1,000 is deposited annually in an account that pays
interest at a rate of 12% compounded continuously.
What is the present worth of the 10-year investment?
P = $1,000(P|A 12%,10)
∞
P = $1,000(5.48097)
P = $5,480.97
P =PV(exp(0.12)-1,10,-1000)
P = $5,480.97

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.3
Annual bonuses are deposited in a savings account that
pays 8 percent compounded continuously. The size of the
bonus increases at a rate of 10% compounded
continuously; the initial bonus was $500. How much will be
in the account immediately after the 10th deposit?

A1 = $500, r = 8%, c = 10%, n = 10, F = ?

F = $500(F|A1 8%,10%,10) ∞
F = $500(22.51619)
F = $11,258.09

Principles of Engineering Economic Analysis, 5th edition

 Continuous Compounding,
Continuous Flow
Not only does compounding of money occur “continuously,”
but also expenditures occur by the hour, minute, and
second! Instead of cash flows for labor, material, energy,
etc. occurring at the end of the year, they occur throughout
the year, even daily or hourly. Hence, funds also flow
continuously.

In the text, we show that the annual discrete cash flow (A)
equivalent to an annual continuous cash flow (Ā), based on
an annual nominal interest rate of r, is given by
A = Ā(er – 1)/r

Principles of Engineering Economic Analysis, 5th edition

Summary of continuous compounding interest factors for
continuous flows.
Find Given Factor Symbol
P Ā (ern-1)/(rern) (P|Ā r%, n)

Ā P rern/(ern-1) (Ā|P r%, n)

F Ā (ern-1)/r (F|Ā r%, n)

Ā F r/(ern-1) (Ā|F r%, n)

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.4
Determine the present worth equivalent of a uniform
series of continuous cash flows totaling $10,000/yr for
10 years when the interest rate is 20% compounded
continuously.

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.4
Determine the present worth equivalent of a uniform
series of continuous cash flows totaling $10,000/yr for
10 years when the interest rate is 20% compounded
continuously.
P = $10,000(P|Ā 20%,10)
P = $10,000(4.32332)
P = $43,233.20

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.4
Determine the present worth equivalent of a uniform
series of continuous cash flows totaling $10,000/yr for
10 years when the interest rate is 20% compounded
continuously.
P = $10,000(P|Ā 20%,10)
P = $10,000(4.32332)
P = $43,233.20
P =PV(exp(0.2)-1,10,-10000*(exp(0.2)-1)/0.2)
P = $43,233.24

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.4
Determine the future worth equivalent of a uniform
series of continuous cash flows totaling $10,000/yr for
10 years when the interest rate is 20% per year
compounded continuously.

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.4
Determine the future worth equivalent of a uniform
series of continuous cash flows totaling $10,000/yr for
10 years when the interest rate is 20% per year
compounded continuously.

F = $10,000(F|Ā 20%,10)
F = $10,000(31.94528)
F = $319,452.80

Principles of Engineering Economic Analysis, 5th edition

 Example 2.A.4
Determine the future worth equivalent of a uniform
series of continuous cash flows totaling $10,000/yr for
10 years when the interest rate is 20% per year
compounded continuously.
F = $10,000(F|Ā 20%,10)
F = $10,000(31.94528)
F = $319,452.80
F =FV(exp(0.2)-1,10,-10000*(exp(0.2)-1)/0.2)
F = $319,452.80

Principles of Engineering Economic Analysis, 5th edition