Lecture #

13
Engineering Economics (MS-291)
Chapter 4
Nominal and Effective Interest Rates

Dr. Muhammad Ullah

Assistant Professor
Department of Management Sciences GIKI
Recap
• Nominal interest rate is Simple and Effective interest rate is Compound
• If compounding frequency is more than the interest period, then
generally
• In practice, we use Effective Interest Rates

• Generalized formula for converting Nominal into Effective .

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 Assignment 1

https://forms.office.com/r/dGwd2uyhKd

Deadline: 11: 45 pm October 10, 2023

Late submissions are not allowed.

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Contents of 4th Chapter
• Understanding Nominal and Effective interest rates.
• Understanding interest rate statements.
• Using formulas for calculating effective interest rates.
• Determining interest rate for any time period.
• Determining payment period (PP) and compounding period (CP) for equivalence
calculations.
• Make calculations for single cash flows.
• Make calculations for series and gradient cash flows with PP ≥ CP.
• Perform equivalence calculations when PP < CP.
• Use interest rate formula for continuous compounding.
• Make calculations for varying interest rates.
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Contents of 4th Chapter
• Understanding Nominal and Effective interest rates.
• Understanding interest rate statements.
• Using formulas for calculating effective interest rates.
• Determining interest rate for any time period.
• Determining payment period (PP) and compounding period (CP) for equivalence
calculations.
• Make calculations for single cash flows.
• Make calculations for series and gradient cash flows with PP ≥ CP.
• Perform equivalence calculations when PP < CP.
• Use interest rate formula for continuous compounding.
• Make calculations for varying interest rates.
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 Example: Effective Annual Rates
You are required to calculate the Effective Annual Interest Rate by utilizing the nominal
rate of 18% per year for different compounding periods (year to week).

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 Equivalence Relations: PP and CP
Payment Period (PP) – Length of time between cash flows

Example: If a company deposits money each month into an account that earns at the
nominal rate of 8% per year, compounded semiannually
In the diagram below, the compounding period (CP) is semiannual and the payment period
(PP) is monthly

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 Equivalence Relations: PP and CP
• It is common that the lengths of the payment
period (PP) and the compounding period (CP) do
not match.
, or
• Time periods of interest rate and the payment
period be on the same time basis.

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𝑃𝑃 ≥ 𝐶𝑃
Example: per year compounded quarterly => length of PP
is defined by the interest period. i.e. PP=1 year and CP=1
quarter
=>

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Example 4.7
Over the past 10 years, Gentrack has placed varying sums of
money into a special capital accumulation fund. The
company sells compost produced by garbage-to-compost
plants in the United States and Vietnam. Figure 4–5 is the
cash flow diagram in $1000 units. Find the amount in the
account now (after 10 years) at an interest rate of 12% per
year, compounded semi-annually.

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 Since PP = year and CP = semiannual
i.e. PP > CP
Example 4.7

Interest rate = 12% per

year

Semi-Annual
Compounding

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 Single Amounts with PP > CP
Example 4.7

Interest rate = 12%

per year

Semi-Annual
Compounding

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 Example: Single Amounts with PP ≥ CP

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 interest
rates: (a) monthly, (b) quarterly , and (c) yearly.

(a) For monthly rate, 1% is effective [n = (5 years)×(12 CP

per
F = year = 60]
10,000(F/P,1%,60) = $18,167
months i and n must always
effective i per month have same time units

(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
quarters i and n must always
effective i per quarter have same time units

(c) For an annual rate, effective i/year = (1 + 0.12/12)12 –1 = 12.683%

F = 10,000(F/P,12.683%,5) = $18,167
years i and n must always
effective i per year have same time units
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 Quick Check
Determine the future value of $100 after 2 years in a saving
account stated interest rate of 15% per year, compounded monthly.

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 Series with PP ≥ CP

For series cash flows, first step is to determine relationship between PP and CP
Determine if PP ≥ CP, or if PP < CP

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

(1) First, find effective per

Example: if PP is in quarters, must find effective i/quarter
(2) Second, determine , the number of values involved
Example: quarterly payments for 6 years yields n = 4×6 = 24

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Example: Series with PP ≥ CP
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: First, find relationship between PP and CP

PP = six months, CP = one month; Therefore, PP > CP

Since PP > CP, find effective per PP of six months

Step 1. i /6 months = (1 + 0.06/6)6 – 1 = 6.15%

Next, determine (number of 6-month periods)

Step 2: n = 10(2) = 20 six month periods

Finally, set up equation and solve for F

F = 500(F/A,6.15%,20) = $18,692 (by factor or spreadsheet)

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 Quick Check

• For the 7 years, Excelon Energy has paid $500 every 6

months for a software maintenance contract. What is the
equivalent total amount after the last payment, if these
funds are taken from a pool that has been returning 8% per
year, compounded quarterly?

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Solution

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 Economic Equivalence where PP < CP
• If a person deposits money each month into a savings account where interest is
compounded quarterly, do all the monthly deposits earn interest before the next
quarterly compounding time?
• If a person's credit card payment is due with interest on the 15 th of the month,
and if the full payment is made on the 1st, does the financial institution reduce
the interest owed, based on early payment?
• The Usual answers are NO!!!! … Some time possible for big clients

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 Series with PP < CP
Two policies: (1) interperiod cash flows earn no interest (most common)
(2) interperiod cash flows earn compound interest

For policy (1), negative cash flows (deposits or payments, depending on the perspective
used for cash flows) are all regarded as made at the end of the compounding period, and
positive cash flows (receipts or withdrawals) are all regarded as made at the beginning.

Note: The condition of with no inter-period interest is the only situation

in which the actual cash flow diagram is changed

For policy (2), cash flows are not moved and equivalent P, F, and A values are

determined using the effective interest rate per payment period

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 Example: Series with PP < CP
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), construct the cash
flow diagram to determine how much will be in the account after 2 years at i =
6% per year, compounded quarterly. Assume there is no inter-period interest.

Solution: Since PP < CP with no inter-period interest, the cash flow diagram must
be changed using quarters as the time periods
F=?
F=? 75 150
75 75 75

from to 0 1 2 3 4 5 6 7 8 9 10 21 24 Months
0 1 2 3 4 5 6 7 8 9 10 23 24
this this 1 2 3 7 8 Quarters
100 300 300 300 300 300

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 Example when PP < CP
• The venture fund manager generated the cash flow diagram in $1000 units from
AllStar’s perspective as given below. Included are payments (outflows) to Clean Air
Now (CAN) made over the first year and receipts (inflows) from CAN to AllStar. The
receipts were unexpected this first year; however, the product has great promise, and
advance orders have come from eastern U.S. plants anxious to become zero-emission
coal-fueled plants. The interest rate is 12% per year, compounded quarterly, and AllStar
uses the no-inter period-interest policy.
• Find net Future Value.

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Solution

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 Solution
i = 12% per year, compounded quarterly

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Continuous Compounding

• In compounding
• For quarterly compounding
• For monthly compounding
• For daily compounding

• When , the compounding is called continuous

• Businesses with large numbers of cash flows each day
consider the interest to be continuously compounded for all
transactions.

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 Continuous Compounding
-------- (1)

We know that The limit of Equation I as m approaches infinity is found

by using r/m = 1/h
Replace in eq(1)

As approaches infinity, the effective interest rate;

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 Continuous Compounding: Example
If a person deposits $500 into an account every 3 months at
an interest rate of 6% per year, compounded continuously,
how much will be in the account at the end of 5 years?
Solution:
Payment Period: PP = 3 months
Nominal rate per three months: r = 6%/4 = 1.50%
Effective rate per 3 months: i = e0.015 – 1 = 1.51%
F = 500(F/A,1.51%,20) = $11,573

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Varying Interest Rates

• Interest rate does not remain constant full life-time of a

project.
• In order to incorporate varying interest rates in our
calculations, normally, engineering studies do consider
average values that take care of these variations.
• But sometimes variation can be large and having
significant effects on Present or future values calculated
via using average values.

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Example: Varying Interest Rates
• Let suppose, you are required to calculate present
worth of the given cash flow series.

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Varying Interest Rates

• When interest rates vary over time, use the interest rates associated
with their respective time periods to find P.
• The general formula for varying interest rate is given as:
P = F1(P/F, i1, 1) + F2(P/F, i1, 1)(P/F, i2, 1) + ….. + Fn(P/F, i1, 1)

(P/F, i2, 1) … (P/F, in, 1)

• For single F or P only the last term of the equation can be used.
• For uniform series replace “F” with “A”.

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Example: Varying Interest Rates
• Let suppose, you are required to calculate present worth of
the given cash flow series.

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 Thank You

Any Questions?
Email:
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