Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Chapter 4
Nominal and Effective Interest Rates

4.1. Nominal and Effective Interest Rate Statements

A nominal interest rate r is an interest rate that does not account for compounding.

r = interest rate per time period * number of periods

A nominal rate may be calculated for any time period longer than the time period stated.

For example, the interest rate of 1.5% per month is the same as each of the following

nominal rates.

Note that none of these rates mention anything about compounding of interest; they are

all of the form “r % per time period”.

After the nominal rate has been calculated, the compounding period (CP) must be

included in the interest rate statement. As an illustration, again consider the nominal rate

of 1.5% per month. If we define the CP as 1 month, the nominal rate statement is 18% per

year, compounded monthly, or 4.5% per quarter, compounded monthly.

An effective interest rate i is a rate wherein the compounding of interest is taken into

account.

For example, 10% per year, compounded monthly, or 12% per year, compounded weekly.

If the CP is not mentioned, it is the same as the time period mentioned with the interest

rate. For example, an interest rate of “1.5% per month” means that interest is

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

compounded monthly. Therefore, the equivalent effective rate statement is 1.5% per

month, compounded monthly.

All of the following are effective interest rate statements because either they state they

are effective or the compounding period is not mentioned. In the latter case, the CP is

the same as the time period of the interest rate.

All interest formulas, factors and tabulated values must use an effective interest rate to

properly account for the time value of money.

Interest period (t): The period of time over which the interest is expressed. This is the t

in the statement of r% per time period t, for example, 1% per month.

Compounding period (CP): The shortest time unit over which interest is charged or

earned. For example, 8% per year, compounded monthly.

Compounding frequency (m): The number of times that compounding occurs within the

interest period t.

Example 4.1

Three different bank loan rates for electric generation equipment are listed below.

Determine the effective rate on the basis of the compounding period for each rate.

(a) 9% per year, compounded quarterly.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

(b) 9% per year, compounded monthly.

(c) 4.5% per 6 months, compounded weekly?

Solution

4.2. Effective Annual Interest Rates

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

The effective annual interest rate formula is:

This equation calculates the effective annual interest rate ia for any number

of compounding periods per year when i is the rate for one compounding

period.

If the effective annual rate ia and compounding frequency m are known, the

previous equation can be solved for i to determine the effective interest rate

per compounding period.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 4.2:

Janice is an engineer with Southwest Airlines. She purchased Southwest stock for $6.90

per share and sold it exactly 1 year later for $13.14 per share. What did she earn in terms

of (a) effective annual rate and (b) effective rate for quarterly compounding, and for

monthly compounding?

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Solution

(a) The effective annual rate of return ia has a compounding period of 1 year, since the

stock purchase and sales dates are exactly 1 year apart. Based on the purchase price of

$6.90 per share

(b)

4.3. Effective Interest Rates for Any Time Period

Example 4.3:

There are three bids as follows:

Bid 1: 9% per year, compounded quarterly

Bid 2: 3% per quarter, compounded quarterly

Bid 3: 8.8% per year, compounded monthly

(a) Determine the effective rate for each bid on the basis of semiannual periods. (b) What

are the effective annual rates? These are to be a part of the final bid selection. (c) Which

bid has the lowest effective annual rate?

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Solution (a)

(b)

(c) Bid 3 includes the lowest effective annual rate of 9.16%, which is equivalent to an

effective semiannual rate of 4.48% when interest is compounded monthly.

Example 4.4:

A dot-com company plans to place money in a new venture capital fund that currently

returns 18% per year, compounded daily. What effective rate is this yearly and

semiannually?

Solution

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

4.4. Equivalence Relations: Payment Period and Compounding Period

The payment period (PP) is the length of time between cash flows (inflows or outflows). It

is common that the lengths of the payment period and the compounding period (CP) do

not coincide. It is important to determine if PP = CP, PP > CP, or PP < CP.

4.5. Equivalence Relations: Single Amounts with PP ≥ CP

If the rate is 8% per year, PP = CP = 1 year.

If the rate is 10% per year, compounded quarterly, then PP is 1 year, CP is 1 quarter or 3

months, and PP > CP.

There are two methods to determine i and n for P/F and F/P factors:

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Method 1: Determine the effective interest rate over the compounding period CP, and set

n equal to the number of compounding periods between P and F. The relations to

calculate P and F are:

P = F (P/F, effective i% per CP, total number of periods n)

F = P (F/P, effective i% per CP, total number of periods n)

Example 4.5:

Assume that the interest rate is nominal 15% per year, compounded monthly. Here CP is

1 month. To find P or F over a 2-year span, calculate the effective monthly rate of 15%/12

= 1.25% and the total months of 2 * 12 = 24. Then (P/F,1.25%,24) = 0.7422.

Method 2: Determine the effective interest rate for the time period t of the nominal rate,

and set n equal to the total number of periods, using this same time period.

n = 2 years, and (P/F,16.076%,2) = 0.7422. The P/F factor is the same by both methods.

Example 4.6:

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. The cash flow diagram in $1000 units is the following.

Find the amount in the account now (after 10 years) at an interest rate of 12% per year,

compounded semiannually.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Solution:

Method 1: Semiannual rate of 6% per 6-month period. There are n = 2 * number of years

semiannual periods for each cash flow.

Method 2:

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

4.6. Equivalence Relations: Series with PP ≤ CP

When cash flows involve a series (i.e., A, G, g) and the payment period equals or exceeds

the compounding period in length:

• Find the effective i per payment period.

• Determine n as the total number of payment periods.

Example 4.6:

For the past 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?

Solution:

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

F = A(F/A,4.04%,14) = 500(18.3422) = $9171.09.

Example 4.7:

The Scott and White Health Plan (SWHP) has purchased a robotized prescription

fulfillment system for faster and more accurate delivery to patients with stable, pill-form

medication for chronic health problems, such as diabetes, thyroid, and high blood

pressure. Assume this high volume system costs $3 million to install and an estimated

$200,000 per year for all materials, operating, personnel, and maintenance costs. The

expected life is 10 years. An SWHP biomedical engineer wants to estimate the total

revenue requirement for each 6-month period that is necessary to recover the investment,

interest, and annual costs. Find this semiannual A value, if capital funds are evaluated at

8% per year, using two different compounding periods:

Rate 1. 8% per year, compounded semiannually.

Rate 2. 8% per year, compounded monthly.

Solution:

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Rate 1. 8% per year, compounded semiannually.

PP = CP at 6 months; find the effective rate per semiannual period. Effective semiannual

i = 8%/2 = 4% per 6 months, compounded semiannually.

Number of semiannual periods n = 2(10) = 20.

Calculate P, using the P/F factor for n = 2, 4, …, 20 periods because the costs are annual,

not semiannual. Then use the A/P factor over 20 periods to find the semiannual A.

Rate 2. 8% per year, compounded monthly.

The PP is 6 months, but the CP is now monthly; therefore, PP = CP. To find the effective

semiannual rate, r = 4% and m = 6 months per semiannual period.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

4.7. Equivalence Relations: Single Amounts and Series with 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 15th 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. These are examples

of PP < CP.

For a no-interperiod-interest policy, negative cash flows (deposits or payments) 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.

Example 4.8:

Consider the following cash flow diagram in $1000. How much is future value at the end

of the year, if the interest rate is 12% per year, compounded quarterly?

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Solution:

Calculate the F value at 12%/4 = 3% per quarter.

If PP < CP and interperiod compounding is earned, then the cash flows are not moved,

and the equivalent P, F, or A values are determined using the effective interest rate per

payment period.

For example, weekly cash flows and quarterly compounding require that m = 1/13 of a

quarter. When the nominal rate is 12% per year, compounded quarterly (the same as 3%

per quarter, compounded quarterly), the effective rate per PP is:

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Effective weekly i % = (1.03)1/13 - 1 = 0.228% per week

4.8. Effective Interest Rate for Continuous Compounding

Continuous compounding is present when the duration of the compounding period

becomes infinitely small and m, the number of times interest is compounded per period,

becomes infinite. Businesses with large numbers of cash flows each day consider the

interest to be continuously compounded for all transactions.

Example 4.9:

(a) For an interest rate of 18% per year, compounded continuously, calculate the effective

monthly and annual interest rates.

(b) An investor requires an effective return of at least 15%. What is the minimum annual

nominal rate that is acceptable for continuous compounding?

Solution:

(a) The nominal monthly rate is r = 18%/12 = 1.5%, or 0.015 per month. The effective

monthly rate is

i % per month = er - 1 = e0.015 - 1 = 1.511%

Similarly, the effective annual rate using r = 0.18 per year is

i % per year = er – 1 = e0.18 - 1 = 19.722%

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

(b) er - 1 = 0.15. er = 1.15 ln er = ln 1.15 r = 0.13976

Example 4.10:

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.

Solution:

Marci: For annual compounding, the future worth is:

F = P(F/P,10%,10) = 5000(2.5937) = $12,969

Suzanne: first find the effective i per year for use in the F/P factor.

Effective i % = e0.10 - 1 = 10.517%

F = P(F/P,10.517%,10) = 5000(2.7183) = $13,591

4.9. Interest Rates That Vary over Time

Example 4.11:

CE, Inc., leases large earth tunneling equipment. The net profit from the equipment for

each of the last 4 years has been decreasing, as shown below. Also shown are the annual

rates of return on invested capital. The return has been increasing. Determine the present

worth P and equivalent uniform series A of the net profit series. Take the annual variation

of rates of return into account.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Solution:

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